Futronomics: contrarian analysis of global macro trends, commodities, currencies, equities

Blog Update

2010-03-05T10:39:00.000-08:00

After quite the party throughout the Olympics here in Vancouver, capped off by a brilliant victory in men's hockey (take that!), I have had some time to evaluate how I am using my time to maximize the return on my existing skills and to simultaneously build skills that can be used in the future. Long-time readers of this blog know that this blog itself has generated no income, nor was it ever intended to do so. Income has been generated by my own speculative activities and some writing assignments for local financial firms.

Five years ago I made a decision to pursue an education on my own terms. A practical education filled with real-world experiences and a "learn by doing" mentality. My other option was "what everyone else was doing." Going to university, racking up $100,000 plus of debts and coming away with a piece of paper declaring my competence. This piece of paper, I was told, would increase my earnings potential by about 20% for the first 10 years of my working life, at which point it would become more or less irrelevant. The math didn't make any sense. With the interest on the debt, even a high starting salary wouldn't pay it off in ten years. And to top it off, I was surrounded by people who already had degrees but couldn't find work in their trained fields. They went back to coaching tennis or doing security. It really was an easy decision.

Over the past five years I have done proprietary trading for a small financial institution, managed my own account, operated this blog, attained a number of professional certifications in the financial services industry, and spent countless hours reading and researching economic theory, business cycle theory, economic history, the financial markets, capital flows and anything in between that interested me at the time. I have had the luxury of doing all this while living for extended periods of time in Europe and South America, gaining important cultural insights. I'm 27. I have no debt and a little stash of savings.

Far from suggesting that I can't learn anything else (the more I learn, the more I learn how little I know), I have indeed reached a point where this sort of self-directed process has met the law of diminishing returns. It has come time for me to apply what I have learned in another fashion.

I again had two options. The financial services industry was where my training naturally directed me toward. But being under 30 with my qualifications only gave me access to a few entry level positions. Positions abound for "investment advisors" at all the major institutions in Canada. They could just as accurately title the position "Shameless Mutual Fund Salesperson", because that is what they do: siphon their customers into a "balanced" portfolio of instruments that garner the highest sales fees possible. I couldn't, in good conscience, resign myself to this pitiful existence. Alternatively, I could be an "Investor Relations Representative" for a small junior mining company. Being paid primarily in stock options, whose value is dependent on some geologist finding a hot hand? Thanks, but no thanks.

So the option remaining is to use my financial background by pursuing small business development. And as it turns out, there is a family business in need of a new manager. It has a stable earnings flow and significant potential for expansion. Starting now, the majority of my time will be spent improving this business.

What this means for my readers, unfortunately, is that regular updates to this blog will no longer be a priority. I will continue to read a good amount of financial news, and thus, should have no problem keeping the "recommended reading" links updated regularly. Surely, I will at some point get antsy and feel like I should write something (or rant about something). Gone will be watching the markets tick-by-tick as I have for these past 5 years. Perhaps eliminating this short term oriented habit will help me gain a different perspective of the markets.

I'd like to thank my long-time readers for their support, encouragement and advice. I have, indeed, gleaned as much insight from your feedback as I have provided to others. And that was my entire motive of this little project.

Thank You!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 06.10

2010-02-15T16:19:00.000-08:00

A week of choppy trading saw the major indices gain about 1 percentage point. There were violent swings in both directions as rumours swirled in Europe of the Greek fiasco. If you've been reading my links on a daily basis, you've probably got a pretty good handle on the issues. I'll summarize the most important points here:

1) The ECB is constitutionally forbidden from acting unilaterally to assist any one nation or group of nations
2) The IMF has a US veto over use of funds and the issue is too large for them to handle
3) Germany and Holland and Scandinavia cannot assist Greece because
i) politics - Germany underwent austerity to facilitate the EU's formation - telling them now to bailout profligate nations is politically impossible
ii) bailing out Greece will immediately lead to eyes laid on Portugal. Then Spain, Ireland, Italy, UK, France, etc.
iii) moral hazard is obvious
iv) adding the debt burdens of Club Med will put Germany's implied debt burden in just as poor shape as Club Med itself. Interest rates on Northern debt would rise
4) Letting Greece fail would cause a cascade of sovereign failures
5) Bank exposure to Greek debts in Germany, France, Switzerland is huge and enough to paralyze their credit markets
6) Nobody can devalue in a monetary union
7) Austerity in Greece, Portugal and Spain is apparently not an option. Workers refuse to accept lower wages. Politicians are resorting to pointing fingers, citing fear mongering and rumour spreading

All routes lead to collapse of the monetary union. Germany bails out one, they must bail out all of them. This will incite political and financial collapse in Germany. Let one fail, the rest will fail by way of precedent and private banks all go down with them. Austerity is politically impossible (unemployment is already sky-high for example). Austerity in socialistically-minded economies will lead to complete depression.

Yet most market analysts continue to believe that "something will get worked out." It is only their optimistic mindset that supports this view, not any kind of sound logic. And the buoyancy of markets is reflective of this. The second leg down in the Great Credit Crisis will be led by the unwind of this baseless optimism toward solutions that don't exist.

See above the multiple 10-15 point swings last week on their way to nowhere. As I often repeat, "oversold conditions can work their way off by either time, price, or both." This week's choppy rise has successfully rooted out many of the oversold readings, and it has done so without inflicting much technical damage to the downtrend.

Also notice the evident complacency among traders, who, despite violent swings in both directions last week put a much lower price on options. Implied option volatilities are worth 23.3% less on the 1075 close friday than they were at about 2:30pm the previous Friday with the S&P at 1044. If that sounds excessive, it's because it is.

We'll see if the greater downtrend prevails this week. Another week of gains would likely put it in jeopardy.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Note To Readers

2010-02-13T17:02:00.000-08:00

Posting will be light over the next few weeks. The Olympics have rolled through my neck of the woods. I took a part-time gig just to be a part of the action, which has naturally turned into full-time with more responsibility than planned. I'd also like to spend some time mingling with the foreigners, etc. Oh, and I'm battling chronic tonsillitis. Nice!

I'll at least keep the links updated and some charts on the weekend, but suffice to say I'll only have one eye on things. I'm sure you'll all be totally lost without me.

I kid.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 05.10

2010-02-08T19:52:00.000-08:00

I'm a little late this week, but with the benefit of Monday's session, I think we have some added evidence for the beginning of a multi-month decline. The character of this latest selloff has a different feel than either the July or October selloffs. I would venture to guess that if I asked people a month ago that we'd have an unemployment rate of 9.7% and GDP growth of 5.7% (annualized), the stock market would be squeezing shorts into oblivion and trudging yet higher toward the heavens.

Not so. Apparently, good news only mattes when, well, when it matters. If the stock market goes down, then the good news doesn't matter and something else does. Got it? Right. Perhaps it is best to pay greater attention to the bigger fundamental picture and what the market does, rather than the monthly or weekly data. People decide what stocks are worth based on their emotions. And their emotions appear to be directed by something other than the monthly data. The best explanation I have found for this phenomenon is that people merely take their emotive cues from each other - oscillating between optimism and pessimism.

Right now, everyone feels panicky about the situation in Greece, Portugal and Spain. But these problems are not new. They've been problems for a good 5 years now. The difference is that people are now paying attention to them. But I am sensing a great deal of complacency about the nature of this decline. Most sound completely certain that it is only a minor correction. And this gives me greater reason to believe that a far larger decline is upon us. See the chart below where a survey of 140 newsletter writers shows quite a decline in bullish sentiment, yet a far smaller increase in bearish sentiment. Notice how the two typically inversely correlate perfectly. But this time, we see a very strong resistance to the idea of becoming outright bearish.

(Data as of last Tues)

Elliott Wave patterns have been extremely compelling on the way down. This is in contrast with the October selloff, where one had to stretch to count 5 waves down and when it rallied, it rallied very compellingly. The bounces on this selloff have been weak and overlapping. The implication is that a 3rd of a 3rd wave down is just beginning. Support resides in the 940-980 range. This count from Daneric's Elliott Wave Blog looks like the most probable from my perspective.

The Euro/Yen cross has been a reliable indicator for risk aversion over the past few years. While I feel that trend will break at some point, it still bears watching.

Gold needs to hold the 200 day EMA to avoid significant technical damage. I think a test of the April lows at $865 is a best case scenario.

The weekly chart of oil is not looking pretty. I've pointed out the bunched up moving averages before, and they usually portend a major move in one direction or another. I still think we see new lows for oil as speculators unwind their positions. A sustained break of $70 would be very bearish.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Themes For 2010 - 6 - Final Thoughts

2010-02-06T17:33:00.000-08:00

Last month, I ran a series of pieces detailing my outlook for credit markets, the economy, asset markets, and government interventions in them.

The overarching theme was that a secular shift had occurred in 2007 toward the reduction of debt and leverage within our economies. 2008 was the point of recognition. In 2009, we experienced a barrage of "fix-its." Most of these programs were designed to either conceal the actual problem, transfer the obligations to others, and to otherwise re-instill confidence in asset price valuations. The natural tendency for market participants to fluctuate between pessimism and optimism resulted in the perception that these programs had worked and that "normalcy" had returned.

But our concept of "normal" had been skewed by the previous secular shift, which was anything but normal. Its duration of over 3 decades was sufficient to eliminate the memories of how a normal economy actually functions. Indebtedness had replaced the role of savings; speculation the role of investment; consumption the role of production.

A number of factors enabled this shift: the fall of Soviet Russia, globalization, productivity enhancing technological advancements, booming demographics, and most importantly, the implicit and explicit government guarantees doled out to the financial services industry.

A number of those factors have reached their points of maximum impact. Others are already reversing. The first baby boomers began retiring in 2007. The impact of this will increasingly show its effects on markets as they liquidate their assets to pay for their retirements. Globalization grew to the point that the social ramifications of its imbalances will force a retrenchment. The cyclical nature of international trade is well documented. And technological progress, while it will always continue, has not experienced the type of long-term investment necessary to garner returns seen in the 90's and 00's.

The only constant is change. But while most are afraid of change, I prefer to embrace it. Every decade sees enormous secular shifts in our markets, yet most analysts, pundits and economists spend a majority of their time trying to figure out how we can avoid, or blunt the effects of such shifts. It is an exercise in futility. I don't expect to be able to alter people's irrational fear of change. I can only point to it in hopes that some can capitalize on it early.

I will reprint the conclusions from the previous installments in this series.

Part 2 - Credit Markets

On the whole, credit markets have not recovered. In fact, in many areas credit quality has continued to deteriorate unabated. A pending supply of low grade mortgage recasts, along with an overhanging inventory of underwater mortgages will likely force a continuing deterioration in loan performance and further house price declines. Despite accounting shenanigans that allow banks to value their assets at whatever they like, banks' lending ability remains constrained, while the ability and willingness to borrow is also under pressure. The overall amount of debt outstanding is also constraining the economy's ability to lend its way out of the recession. Even with historically low rates, the high level of debt gives us a servicing ratio that constrains our ability to invest in productive capacity.

Part 3 - The Economy

We are most likely (as of June '09) in the midst of a technical recovery as defined by GDP. But this masks the rot underneath the surface. Consumer credit and income growth are contracting. As such, personal consumption expenditures will likely remain depressed for some time. Short term gimmicks like "cash for clunkers" and homebuyer tax credits may provide incentives for consumers to delay their deleveraging, but the cost of the programs add to the overall debt burden, which needs to be paid with interest. High debt servicing burdens hinder our ability to invest. In the long run, these programs are detrimental to GDP - even though they may provide relief in the near term.

Structurally high unemployment will likely persist, as those who have recently fallen out of the workforce will join it again upon improving job market fundamentals. This will serve as a drag to economic robustness, but should keep wage pressures low for a considerable amount of time. Declining wages will increase productivity and likely bring about a revival in the US goods-producing industries that have shed jobs for 3 decades.

The picture I have painted above is very deflationary. Combined with contracting credit markets, valuations of financial assets should decline to reflect their weak earnings potential. I will discuss the implications of a rebalancing economy and contracting credit on asset markets later this week.

Part 4 - Government

A vast majority of the $23.6 Trillion in bailouts, swaps and guarantees has been directed toward supporting home prices. For the most part, they have failed. The natural course is quite obviously for home prices to continue declining toward levels commensurate with incomes and revenue generation ability. The expiration of many temporary "kick the can down the road" schemes, along with a flood of Option-ARM and Alt-A recasts, will significantly hamper bank balance sheets and eventually force further credit writedowns. Populist anger toward big bank favouritism will also limit the government and the Fed's ability to enact further legislation favourable to banks.

Part 5 - Asset Markets

Credit contraction and asset price deflation are two peas in the same pod. As I believe credit contraction is unavoidable over the long-term, I also see lower asset prices ruling the roost. In many cases, a return to historical valuation levels would imply drastic reductions in prices. This should be viewed in a positive light. Lower asset prices enable lower wages, which restore competitiveness and lays the foundation for a robust economic recovery. Whether this happens in 2010 is to be determined. But I feel that the probabilities are strongly in favour of such a scenario.

With all that in mind, I'll proceed to my "Themes for 2010." The normal qualifications are required. Some of these themes will be correct, others will be laughably false. Such is the nature of prediction in a dynamic system. Many of these themes are very long-term in their nature. While pressures may build, many may not necessarily "peak" in their effects until many years down the road. For example, this will be the third year that I have highlighted the stresses in state and municipal governments. I have not necessarily been wrong in the past two years, as the problems have continually grown in both their size and realization in the mainstream. Indeed, it will likely take many more years for a long-term solution to be found. Such is the case with much of the below.

- a resumption in the trend toward deleveraging and falling prices for most liquid assets (stocks, commodities and corporate bonds)
- a consequent rise in the US Dollar Index, perhaps very substantially so as credit contracts
- decreasing global trade and a continuation in protectionist measures, primarily directed toward China
- outright collapse of China's bubble-economy as foreign capital flees. Chinese officials blame everyone but themselves
- movement toward surplus for America's trade deficit
- sovereign debt concerns roil Europe, the Middle East and perhaps even Japan
- state and municipal debt concerns accelerate, pitting unions and pensioners vs. everyone else
- another leg down in North American real estate prices - especially Canada's largest markets
- growing dissent within the Obama Administration as populist anger disables government's favourable treatment of the FIRE industry ahead of midterm elections
- falling salaries for sports stars and actors/entertainers as discretionary spending wanes on event tickets
- relative bright spots will include South America (specifically Brazil, Chile, Colombia and Peru) and personal wireless devices.
- the US manufacturing industry begins a revitalization

Regardless of what happens, I wish my readers a prosperous 2010!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Must Read Articles 05.10

2010-02-04T12:20:00.001-08:00

If you're wondering what all the hubbub is about Greece, Portugal and Spain, I've grouped together a set of articles that explain the situation lucidly. Like most of the world's economic problems, it can be summed up by the simple phrase "there's too much debt." But in Europe, individual governments are restrained from printing money to temporarily relieve the stress. The only other cited cure is for public and union workers to take massive pay cuts in order to regain competitiveness. Socialist-leaning governments in these countries are not treating that like a legitimate option and appear to be losing control. They've now resorted to blaming their problems on "speculators." Euro-skeptics have always said this would eventually prove to be the undoing of the Euro. Right now they're being proven correct in spades.

While most of the focus lies on government debt, please remember that private banks in this region are even more susceptible. Credit default swaps (CDS) on Portuguese banks, for example, are up 30% today. That's no small potatoes. And Europe's banking system is just as systemically intertwined as is America's. If Club Med banks start going down, the big northern banks will likely follow.

The only actual solution to this problem is the only one everybody seems to agree is "not a solution." Debt repudiation.

Spanish Canary in the European Coal Mine (Rolfe Winkler)

If PIIGS Could Fly (Neils Jensen, Absolute Return Partners via Credit Writedowns and John Mauldin)

Should Germany Bail Out Club Med or Leave the euro Altogether? (Ambrose Evans-Pritchard)

Funds Flee Greece As Germany Warns of "Fatal" Eurozone Crisis (Ambrose Evans-Pritchard)

And now for some other issues:

Demand For Loans Weakens Again in Fed Senior Loan Survey (Mish)

It is easy to blame banks for not lending money to people who "need" it. President Obama does it all the time. But the problem is not that banks won't lend, it's that there's nobody willing to borrow that is remotely credit-worthy.

Saving, Asset Price Inflation and Debt Induced Deflation (Michael Hudson, via mannfm11)

Hudson follows a similar train of thought as Steve Keen. Neither are Austrians. They both maintain that Keynes was misinterpreted and combined with destructive "equilibrium based" theories. This is the most compelling of non-Classical Liberal theories I have come across.

On Depreciation, Malinvestment and GDP as a Gross Number (Ed Harrison)

All things I like to talk about. GDP is calculated based on aggregate spending data. Not all of that spending is worthwhile and beneficial. In fact, some of it is downright harmful. Eventually, that must be realized. The process of realization is otherwise known as "recession."

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 04.10

2010-01-30T07:53:00.000-08:00

Continuation to the downside in equity, commodity and foreign currency markets as the total decline now exceeds the late October selloff in both duration and degree. Market character was very bearish all week, as large cap indices trended down, making a series of lower highs and lower lows. The Nasdaq, Semiconductors, Transports and Small Caps all underperformed the broader market.

The fall has occurred in conjunction with the start of earnings season. So one would be led to believe that earnings have been very poor. They would be wrong. From CNBC:

Of the 220 (~44%) S&P 500 companies who have reported Q4 results, 78% beat estimates, 8% were in-line, and 14% were below estimates.

Even optimistic earnings expectations have been surpassed, yet the market has "sold the news" apparently. Or perhaps it was just going to fall anyway and people have thus ignored earnings and focused on other perceived "catalysts." This has most noticeably been the case in the large-cap tech sector with GOOG, AAPL, QCOM among others beating expectations, but being sold in the aftermarket and experiencing a continuation of that selling in subsequent days. This is the "change in market character" that I have been awaiting for numerous months now.

Two quarters ago, I mentioned that the boost in earnings was, in many cases, merely a reflection of cost cutting, inventory restocking and increased productivity from employers terrified of losing their jobs. I argued that without a recovery in consumer balance sheets, employment, capacity utilization and private fixed investment, the recovery in corporate profits would prove temporary.

The above chart includes preliminary estimates for private fixed investment in Q4. Nothing too spectacular. So I am wondering if analysts are starting to look out a few quarters, knowing that the temporary boosts will have worn off, and seeing that recovering to trend growth is going to be a very difficult task...?

The moment said analysts look away from their mathematical models, which naturally forecast a recovery to trend growth as a given, is the moment they start to rethink the assumptions they have made. And when they do that, present equity valuations simply do not make sense - especially at the point of the business cycle they believe we are in (trough).

Looking at this socionomically (ie. a Prechterian PoV), it all makes a lot of sense. We have people switching from interpreting every piece of information as a positive to now questioning those interpretations, while increasing public anger toward public officials and bankers is growing rapidly. (See the continuous revelations of the AIG-NY Fed-Goldman dealings). At the same time, we are seeing strongly impulsive moves down in the stock market, while corrections are occurring in sharp, overlapping waves, and often peaking in the futures market overnight before selling-off toward the open. If a "P3" move down is going to happen as Elliott Wave Theory seems to strongly suggest, then this is precisely the type of environment one would expect.

Staying on the Elliott Wave theme, I should note that it is not always the best tool to use. I find that if the pattern cannot be immediately identified as obvious, then other TA methods should be used instead. But if I look at a pattern and see the waves immediately, I lend a much larger weight to their validity. Take for example a multi-year chart of the USD Index. The dollar completed a very evident 5 waves up during in '08, followed by a 3 wave decline in '09, and has now turned up quite violently. If a 3rd wave up is what's coming, it should be sharper and longer than the previous up wave. And this is precisely how one would expect it to begin. I've been calling for par with the Euro for a couple of years now. The chart below suggests that is what we'll see.

Let us not forget the carry trade that was a popular idea a few months ago, but seems to be forgotten right now. Those that are losing money on the stock market selloff are in many cases also losing on the currency side. With emerging markets selling off over 10% and the US Dollar higher by 7%, the pain is being felt more than a 6.7% S&P correction would otherwise indicate.

The Volatility index moved sharply higher last week, but sold off without a corresponding recovery in stock prices. This demonstrates complacency among options traders and could require them to panic and cover their bets should the divergence persist much longer.

Lastly, this is a chart of the percentage of stocks above their 200 day moving average. Notice that this is the type of indicator that moves in long waves, oscillating between many above and then many below. Further correction should be forthcoming.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Must Read Articles 04.10

2010-01-28T11:00:00.000-08:00

Note: I'll hopefully get my final "Themes" piece out this weekend or early next week. Sorry for the delay. I've been inundated.

This week's must read articles

Taibbi assaults criticizing wall street populism meme (Yves, Naked Capitalism)

Indeed, this is getting to me too. Somehow the tables got turned on common sense. Now, anyone who criticizes Wall Street is simply labeled a "populist" thereby inferring a depart from rationality. Not all populism is wrong-headed.

The total debt relative to GDP trumps everything else (Comstock Funds)

Comstock picks up on many of my themes, primarily private sector debt deleveraging. They see a reduction in the amount of private debt from $40 Trillion to 20 or 30. I agree.

The economic case against Bernanke/ (Steve Keen)

Keen dismantles Bernanke's adherence to faulty interpretations of the causes behind the Great Depression. Irving Fisher lost nearly his entire net worth betting against the possibility of depression in the 30s. His reasoning was the same as Bernanke's is now. After some reflection, Fisher concluded that debt does matter, and that its growth led to an unnatural perception of stability. A stability that was later revealed to be a bubble, followed by a bust. Bernanke appears desperate to re-learn Fisher's lesson.

Update on residential investment (Calculated Risk)

Being one of the leading indicators for economic recovery, residential investment is obviously an area to keep an eye on. But even more important is the ramifications for major banks with trillions in mortgage assets on their books (and off). They are hoping for a recovery in home prices to make these bad loans whole again. The data does not support such a scenario. In fact, prices are again falling and subsidy infused activity is now drying up.

The debt monster may threaten governments more than corporations (Econblog Review)

EBR notes that the cost of insuring against default for many of our largest conglomerates has fallen below that of insuring against sovereign default.

With that, I would also note that sovereign CDS spreads for troubled countries in southern Europe are absolutely blowing out. Bond spreads are doing the same. Greece, Portugal and Spain are in the most trouble - in that order. This is a problem that doesn't appear to be going away. I doubt it comes to a head in the near term. They'll likely find a half-measure or two before the inevitable occurs.

Related to that are long-term issues with Japan. See the video below from Kyle Bass.

Ever wonder why there is never agreement on anything when it comes to economics or finance? You'll be happy to know this is nothing new. In fact, the same arguments have been going on for more than a century. I doubt it will ever be resolved, as people have different value structures toward stability, freedom, wants/needs, etc. The video below explains it well and in a very entertaining format. Enjoy!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 04.10

2010-01-24T10:13:00.000-08:00

Whack! Just like that, nearly 3 months of slow, grinding gains were eliminated in three days of trading. The selling intensified into the close on Friday. It seem that every time three days of selling close out a week, analogies to 1987 get thrown around. While I don't expect anything like that to occur anytime soon, this is indeed the type of action one would expect to see if "the big one" still lied ahead. Long periods of perceived stability breed complacency.

And the last few months of trading have certainly given the impression of complacency as most stocks have returned to their cyclical high valuations, despite earnings that remain in the dumps compared to their cyclical high earnings of '07. Many have also taken it for granted that banks are earning their way out of trouble, completely ignoring the multi-trillion dollar portfolios of toxic assets that are temporarily held off-balance sheet. While most have just assumed that FASB will never grow a pair big enough to enforce GAAP, they seem to forget that eventually these distressed debt instruments mature. So unless home prices start rising again soon, these losses will be realized eventually. Unfortunately for them, home prices have begun falling again (as of the most recent Core Logic numbers from November). The overhang of inventory (ie. shadow inventory) has clearly started to matter again.

Isn't it funny how things that seemingly "don't matter" all of a sudden become important? Like sovereign debt problems. Or funding crises at state and municipal pension funds. Or sour commercial real estate loans causing small regional banks to fail at an increasingly rapid rate. Or skyrocketing delinquency rates on credit cards, HELOCs, and FHA/Fannie/Freddie loans. It costs money to maintain these operations. One way or another, resources are being redirected from what they would otherwise be doing toward trying to plug these black holes. And this misallocation of resources is precisely what will keep the economy from recovering - just like Japan but without exports to fall back on.

This week's selloff may not be in reaction to these cumulative imbalances finally exacting influence on the stock market. After all, as I'll show below, internals are in better shape while oscillators are more oversold than during their late October corrections. This could be just another correction. Until markets display a change in character, it would be wrong to assume another leg lower has begun. Then again, after 10 months of gains, markets may have sufficiently done their job to turn even bears cautious.

Now, some charts:

S&P Daily. Selloff only takes this average back to the bottom of its trend channel. Notice how the RSI is lower than at any point since the rally began. Does this signify a buying opportunity? Or is it a signal of the higher intensity of the selloff and thus a change in market character? I suppose it depends on how one looks at it.

Similarly, Crude Oil has been trending in its own channel, but while stocks are a good 15% higher than their June highs, oil has not yet signaled any increasing industrial demand since the summer (when many contend the recession ended). There is a confluence of support between $70-72.50.

And internals. Most remain in stronger positions than at their July and early November cyclical lows. Again, this could be indicative of strength, or could simply mean they have further to fall before finding support.

Advance/Decline Volume Ratio

Advance/Decline Issues Ratio

% of stocks above their 50 day moving average

Put/Call Ratio

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Must Read Articles 03.10

2010-01-20T09:40:00.000-08:00

Starting this week, I'll begin posting a brief list of what I consider to be the last 7 days' most important reads. For those that have been utilizing my "Recommended Articles" widget on the right-hand side of the page, you'll notice that I sometimes add notes to the end of articles I find to be particularly noteworthy. As I do read a copious amount of information on a daily basis (my Google Reader account tells me I go through more than 100 blog posts, newspaper articles and reports daily), I try to share only 10% of that in the sidebar. For most people, I can understand even that is excessive and too cumbersome to delve through daily. And to be honest, for most people with a more long-term focus, I don't see how reading more than a few articles per week would be very beneficial.

As such, I'll be pulling out just a few of the "Must Read" articles and posting a quick caption on their importance. I'll try to do this mid-week as it is warranted.

Must Read Articles of the past week:

A Contrarian View of China - Corriente Advisors (hat tip reader Roger)
Corriente gives an in-depth but easy to read presentation on the state of affairs in China. The consensus of China's situation (plenty of savings, solid growth, booming domestic market, etc) is incredibly one sided. And this report tears many of those misconceptions to shreds. As we know, the consensus is rarely right - especially on matters as opaque as China's debt and currency markets. I find their take compelling.

Debt and Deleveraging - McKinsey (ht Rolfe Winkler)
Lengthy and Exhaustive, a team of researchers has compiled a list of more than 40 historical examples of deleveraging across many countries since the Great Depression. As the title suggests, McKinsey believes our excessive debt levels will result in a prolonged period of deleveraging. But they go one step further and attempt to identify precisely which sectors within the various economies are most likely to undergo this process. They argue that among four primary ways to deleverage (austerity, inflation, default, and growth) we are most likely to take the most common among them - which is austerity. I think default is a higher probability than they're willing to admit. Well worth the read - if only for the intro (pp 9-17).

A Measurement of the Economy - Annaly Capital Management
Annaly challenges the wisdom of relying on GDP for an accounting of the nation's health. They prefer to look at "what the nation earns, rather than what it spends." I agree with this, as it cannot be exogenously influenced as easily. With this metric, they look at tax receipts and conclude that a recovery is unlikely until people start producing, and thus earning, more.

To us, a rebound in GDP only reflects a rebound in consumption, and today’s consumption is fueled to a large extent by growth in government spending, incentives and, most significantly, borrowing. A rebound in tax receipts, sans tax increases that stymie economic activity, would reflect growth in our country’s earning power.

Option-ARM Update - Calculated Risk
As the title suggests. A short recap of what's to come for recasting Option ARM mortgages - which in most instances were just as poorly underwritten as subprime mortgages.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Themes For 2010 - 5 - Asset Markets

2010-01-19T06:52:00.000-08:00

In the last three installments of this series I have covered the credit markets, the economy and the government's influence on each.

The picture painted is one of a continuing deflation. This deflationary process should not be seen as "armageddon" or a "bottomless spiral" as some like to imply. It is a removal of excessive debt levels that will otherwise hamper the economy's ability to grow based on its typical catalysts: savings, investment, and production.

Governments, working in conjunction with their central banks, have attempted to remedy the adverse symptoms of recession with conventional and unconventional measures. The unconventional measures (massive bailouts, asset swaps, accounting shenanigans) will not and cannot prevent the eventual realizations of losses outstanding on bad loans and their derivatives. This reality will hinder banks' ability to lend at low rates to risky borrowers, thus cutting off one engine of typical recoveries. Conventional measures (low interest rates, fiscal stimulus) serve as a disincentive to save, and thus hinder the economy's desire to spontaneously and creatively adapt to a new environment.

Large investment houses, hedge funds, and analysts are assuming that the recession of 08-09 is a normal inventory retrenchment, rooted in overcapacity. Taken together with the conventional and unconventional measures noted above, they almost unanimously agree that a "V-shaped" recovery will ensue, as they have before. In 2007, they all unanimously agreed that there was no overcapacity, and therefore could be no recession. As they were proven wrong for ignoring the debt side of the equation then, so will they again. This was not a normal recession. It was brought on by a credit contraction for the first time since the Great Depression.

The unanimity of opinion on this matter should not be understated. Nearly every investment/business professional (+/- 90%) has received their education from the same sources that suggest a) credit growth/contraction has no appreciable impact on the business cycle or the structure of production; b) aggregate debt levels are irrelevant because "we owe it to ourselves." They are wrong on both accounts.

The mathematically based assumptions of these professionals not only influence their views on an imminent economic recovery to "equilibrium" or "potential output," but they influence their views on how asset markets in general will respond. Naturally, these mathematical models with all their flawed assumptions paint a very favourable picture for stocks, corporate bonds, commodities and foreign currencies.

Because I operate from a different perspective, focusing on debt and the effects it has on growth patterns, my views on asset markets are also different. I see the present (and pre-bubble) valuations of these assets as being determined on the availability of credit and thus the ability for people to borrow money for speculative purposes. Comparative valuation analysis of the past 30 years (during which credit growth was excessive) with the previous 100 years of data is supportive of this claim. To date, I have found no other explanation for these discrepancies.

The value of any asset is primarily owed to its ability to generate cashflow. The value of an apartment building is the amount of rents it can generate over the projected life of the building minus property taxes, maintenance costs, and depreciation. But over the past few decades a premium has been applied to this. Because interest rates have been held below the rate of credit growth, asset prices can reasonably be expected to increase. It is a simple calculation for speculators: if outstanding credit is expanding at 8% per year, then the price of an asset should rise to reflect the total amount of credit available to purchase it. But if interest rates are at only 5%, then owning the asset yields a greater return than a savings account.

Neoclassical economists assume that people make decisions based on aggregate levels of inflation (like the CPI). They use that assumption to fix the cost of money (interest rates). Again, they are wrong. People make decisions based on real-life scenarios like that described above, not nebulous, aggregate statistics. The result is that a massive premium has been applied to the value of all assets based on future implied rates of credit growth. That credit growth has hit a wall and is now contracting - as illustrated in Part 2 of this series. In 2008 and early 2009, asset prices successfully eliminated that future implied rate of credit growth from their valuation. But the efforts of governments and central banks have reapplied it by promising to fight credit contraction with all means necessary. Those efforts are failing. It is my contention that markets will eventually realize that credit expansion is not coming back anytime soon and asset prices will again need to readjust to more conventional valuation metrics.

Equities

To avoid being sensationalist, I will use the most conservative valuation metric available. The Shiller 10-year real P/E. It takes the last decade of operating earnings, and adjusts for inflation (CPI). Keep in mind that over the last decade, companies booked profits on many sorts of malinvestment like originating bad loans. That all gets counted under "normal operating revenues." But when the loans get written down, they are "one time charges" and therefore don't get counted.

Even using this valuation metric, it is apparent that stocks are at least 25% overvalued from their historical mean. If the economy is indeed in the early stages of a new business cycle as most suggest, then this overvaluation is unprecedented for that position. Valuations have always been much lower for the first few years of an economic expansion. The forward expectations for corporate profits to justify present valuations are out-of-this-world optimistic. David Rosenberg of Gluskin Sheff comments:

We should add here that on a Shiller real 10-year “normalized” earnings basis, the S&P 500 is now trading at 20x, which is 25% above the historical average of 16x. This is the same level of overvaluation heading into October 1987, though at the bubble peak in October 2007, the overvaluation gap was 70%. At the average of prior market peaks, the extent of the overvaluation is 50%. We are not saying that equities as an asset class is in a bubble but they certainly have moved to an overvalued extreme.

Moreover, as we have pointed out recently, what is “normal” is that every percentage point of nominal GDP growth translates into 2.5 percentage points of profits growth. Most economic forecasters see nominal GDP growth at 4% for this year. But strategists see, on average, 36% profit growth. But that 4% growth in nominal GDP is only enough to boost profits by 10%, if the normal relationship holds up. To see such low nominal growth and such strong profit growth is a 1-in-50 event. Maybe the economist and strategist at the Wall Street research houses should sit down with each other.

Analysts are expecting $75+ in earnings for 2010. Based on those estimates, and today's current S&P 500 level of 1148, stocks are trading at a P/E of 15.3. That is considered "fair value." Unfortunately, analysts are a fairly rosy-eyed lot. Even last year they expected to see around $77 in earnings. All they got, even with phantom profits at big banks from accounting breaks, was mid-50s. Again, the rate of profit growth needed to achieve this feat is unprecedented. Readers are free to take those projections at face value. But given the track record of these analysts, one would be wise not to.

So my view is that equity markets will correct to valuation levels commensurate with a trough in economic growth. This is heavily dependent on the credit markets, which are the basis for these present overvaluations. If credit continues to contract, then the inflated earnings from previous credit expansions will prove even more elusive. I project trough "operating" earnings (in a period of contracting credit) somewhere between $38-48. If trough valuation levels are applied to this (6 or 7 in the chart above, but we'll use 10 to be conservative), one can expect the S&P to bottom somewhere between 400-500. How soon that occurs depends largely on the rate of credit contraction, and the amount of time it takes to deleverage the economy sufficiently so that growth can take root from more sustainable levels.

I fully expect that certain sectors of equities and perhaps even certain markets (like South America) have very likely already put in major bottoms. But all assets worldwide are credit sensitive, so a prolonged contraction could still have very noticeable effects on even those areas that are recovering.

Real Estate

Perhaps more than any other asset, residential and commercial real estate is dominated by credit availability. For centuries it has been a common rule of thumb that homebuyers are able to afford 3x their household incomes for the purchase of their primary residence. Banks would almost never lend more than this. But this all changed in the 80's. As quantitative finance and exotic mortgages became normal practice, justifications were found to lend up to 10x one's income for the purchase of a home.

As mentioned above, an asset's value is its ability to generate cashflow. This means rent for real estate. And at present valuations, most areas are still selling at 20x yearly rents or higher. Like stocks, average valuations for real estate are around 12-15 depending on the type and location of the property. We will likely return or sink below those levels prior to a bottom in real estate prices. For bubble areas like Vancouver, this means drastic price reductions or drastic rent increases. Because people can't borrow to pay rent, rents are determined solely by wages. Thus, the only way for this imbalance to be rectified is by either enormous wage increases or price declines. I'll let you figure out which is most likely.

One way or another, we will return to tried, tested and true mortgage practices. This means 3x average household incomes correlates with the average home price. It means mortgages are not issued without a 20% down payment. It means loans are only made if total debt servicing (including credit card, car loans, etc) accounts for less than 40% of one's income. And it means that owners of buildings buy them for their rental revenues - not price appreciation differential over the cost of borrowing.

Most would consider my projections to be apocalyptic. They are merely reversions to long-term historical means. If asset prices were at such levels for hundreds of years before, I can assure you that were they to go back to said levels the sky will not fall, the seas will not boil. And no, the earth will not be covered in eternal darkness (although for investment bankers, living hell may be an appropriate analogy).

Commodities

I am of the view that commodity prices are impacted by speculative credit flows. I also believe that a fair bit of "hoarding" has occurred in some markets, which has elevated commodity prices past levels that would likely prevail otherwise (read: China).

So to be consistent, I do expect commodity prices in aggregate to decline over the coming years. This decline should take prices back below their March lows. The recovery in the CRB just looks choppy and corrective.

Within the commodity complex, I continue to believe that gold and agricultural commodities will hold up best. But they will be far from immune should credit contract the way I believe it will. Should gold rise past $1160, I see a non-trivial possibility of a blowoff leg higher toward $1800. As of now, I am expecting lower prices over the next year.

Bonds

Corporate bonds are in the same boat as equities in my opinion. Excluding a couple dozen high-quality borrowers, most corporate issues are risk assets - largely dependent not on ability to repay principal, but on the ability to refinance at maturity.

Government bonds, on the other hand, are a different story. I can understand cases for both extremes on long term interest rates. Should sovereign concerns spread in Europe and elsewhere, risk premiums could begin to be priced in to US, UK and Japanese debt. But I also see the possibility of another "flight to quality" like we saw in 2008. I have no edge on this scenario, so the best I can offer is to stay away from long-term bonds and instead stick to shorter maturities.

Conclusion

Credit contraction and asset price deflation are two peas in the same pod. As I believe credit contraction is unavoidable over the long-term, I also see lower asset prices ruling the roost. In many cases, a return to historical valuation levels would imply drastic reductions in prices. This should be viewed in a positive light. Lower asset prices enable lower wages, which restore competitiveness and lays the foundation for a robust economic recovery. Whether this happens in 2010 is to be determined. But I feel that the probabilities are strongly in favour of such a scenario.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 03.10

2010-01-17T07:23:00.000-08:00

A late week selloff resulted in negative performances across most major indices. Particularly interesting is the recent underperformance of prior star sectors. The Nasdaq failed to make new highs on Thursday and was the worst performing major index on the week. The large contributor to this phenomenon was the sharp selloff in the semiconductor sector. After reporting earnings aftermarket on Thursday that the media characterized as "crushing estimates," Intel stock immediately skyrocketed higher (5%) in the aftermarket. But it quickly ran out of gas. It closed the afterhours session back where it began, opened Friday morning lower, and continued to fall all day, closing down more than 3% on its highest volume of the past two years. Textbook exhaustion reversal on good news.

Intel has been one of the darlings of the technical recovery, nearly doubling since its bottom in March. Its earnings have kicked off "better than expected" earnings seasons in most quarters, setting the bar for everyone else. They have reported strong sales to nearly all groups - business, consumer and emerging markets - suggesting that technological investment may be higher than aggregate numbers suggest. As I wrote in my Themes for 2010, Part 3 article on the economy, I challenged the consensus that a recovery was going to be led by the consumer/credit growth and suggested instead that it would eventually come from investment. Thus, Intel (along with IBM, QCOM, CAT, and other makers of productive capital) are my bellweathers for a legitimate recovery.

See below a comparison of the Semiconductors Index vs. the Dow Industrials.

Readers should also notice that two other important earnings releases (Alcoa and JP Morgan) also disappointed last week. Keep in mind that the year-over-year comparisons this quarter are totally wacky. Q4 of '08 was writedown central for most companies. So the actual performance will be more interpretive than usual, and thus more liable to the sway of human emotions. I suggest readers take the time this week to listen to some conference calls and try to glean some info based on tone and CFO confidence.

That's all for now.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Themes For 2010 - 4 - The Government

2010-01-15T08:29:00.001-08:00

I'm loathe to add this section to a series of articles typically directed to investors and speculators. But it is undeniable that the government and central bank actions of the past few years have had large impacts on everyone's portfolio. To a certain extent, I support the idea that over the long-term, market intervention proves irrelevant. No force is larger than the market. So even though various interventions appear to have great short-term impacts on our investments, I don't think it is instructive to look at what the government "wants" to achieve over a 5 or 10 year period and structure a portfolio thereupon.

The government/central bank duo are herd followers by definition. Bureaucracies are inherently incapable of acting proactively. They are reactive. It is for this reason that centrally planned economies always fail. You may call the market interventions of the past few years (not forgetting those over decades prior that caused the crisis) whatever you like: socialism, corporatism, crony capitalism, kleptocracy. Whatever. The term used is not important (nor are many of the terms particularly useful after decades of redefinition). What is important is the immediate objective of nearly every intervention: Price Fixing

"I don't think it's a bad thing that the bad loans occurred. It was an effort to keep prices from falling too fast. That's a policy."

-- Chair of the House Financial Services Committee Barney Frank - Oct 9, 2009

Just to nip any allegations of conspiracy in the bud, the quote above illustrates the explicit nature of these price fixing objectives. Both monetarist and keynesian (aka. neoclassical) economists are literally terrified of falling prices. Therefore, they target positive rates of inflation on a year-to-year basis. Many classical economists suggest that it is precisely this price fixing that led to most of the excesses and imbalances precipitating the crisis in 2008. If prices were mandated to rise, why not borrow money to speculate on rising prices? That is the train of logic that I subscribe to, but I won't delve further into that debate, as considerable ink could be spilled.

Thankfully, for those of us who prefer to see markets discover prices on their own, we can take solace in the fact that never in the history of price fixing has it ever achieved its objective. Not once. The reason this is so, is that in order to keep prices either above or below the level they can be sustained by incomes and revenues, a greater and greater amount of capital is required to be directed toward this goal. Eventually the cost or the political implications of doing so exceed the implied cost of allowing the market price to prevail. The price fixing scheme collapses and prices revert toward equilibrium (toward - but they never arrive). The same holds true for monopolies.

In the meantime, however, prices can be influenced by these measures. Because it is widely acknowledged that it is real estate prices that led to the deterioration of bank balance sheets, and it is a collapse of the major financial institutions that politicians and central bankers are trying to prevent, most of the price fixing schemes are directed toward supporting home prices. Let's discuss some of the schemes being employed.

Asset purchases - both the Fed and Treasury have involved themselves in the buying of trillions in mortgage backed securities. This has obscured the rate of interest (to the downside) making homeownership more affordable.

FHA balance sheet swelling - When it became apparent that Fannie Mae and Freddie Mac were essentially toxic waste dumps for bad mortgages and were put into gov't receivership, a new source of funds "needed" to be found - lest demand for mortgage securities fall and interest rates rise. Enter: The Federal Housing Administration. Their balance sheet skyrocketed and they became the buyer of a vast majority of MBS that were previously bought by Fannie and Freddie. Because Fannie and Freddie worked out so poorly, the obvious course of action was to do the same thing again - only this time, making the taxpayer the explicit buyer.

Foreclosure moratoria - numerous state governments and financial institutions have declared moratoria on foreclosures. By not allowing these foreclosures, people who are no longer paying their mortgages are being allowed to stay in their homes at no cost. The "logic" behind this is that foreclosures result in bank auctions which decimate property values, thus affecting bank balance sheets.

Modifications - numerous attempts to modify the existing delinquent or risky mortgages have all failed. They are trying to extend the mortgages even longer in duration, lower rates for the first few years, etc. Basically, they're trying to turn prime mortgages that never should have been issued into subprime or Option-ARM mortgages. Anything to avoid forgiving principal outstanding - because that requires balance sheet writedowns for the banks. Typically (and unsurprisingly), these modifications end up re-defaulting in ridiculous numbers (40-70%) after only 6 months or a year. But the purpose they do serve is to kick the can down the road. And they've been doing enough kicking to put any Detroit Lions punter to shame. Their hope is obviously that home prices will start rising again, bringing these homeowners back above water. They're dreaming.

Accounting shenanigans - Perhaps the most egregious example of market intervention has been the suspension of Generally Accepted Accounting Principles (GAAP). Admittedly, this is the one intervention I never expected in 2009. I should have known better. What has typically separated America from the rest of the world is accounting and balance sheet transparency. They threw all that away in 2009 when the US Treasury strongarmed the FASB (Federal Accounting Standards Board) to suspend FASB 157 (mark-to-market accounting). This allowed banks to value their assets at whatever price they wanted. Originally, this was going to be until yearend. Then it was extended. Had it still been in effect, as much as $5 trillion in "off balance sheet" assets would need to be revalued at their true prices. This would have made the big banks insolvent (again). This also facilitated greater market liquidity, better capital ratios, lower leverage ratios and therefore lower interest rates.

The above programs (and, to be sure, there are others) have only worked to a small extent. As of October, home prices have risen only modestly from their bottom. In year-over-year terms, they are still down approximately 6-7%. The stunning price declines of early 2008 were largely abated by the above programs. Indeed, the low interest rates encouraged many to buy their first home, move-up, or to change locations. Investors have also stepped in. I know of a number of folks here in Vancouver that have picked up vacation homes in Arizona and California. See below a number of different home price indices through October numbers.

Not exactly breathtaking, considering the many trillions of dollars that have poured into supporting prices. Surely, much of this will prove to be malinvestment, throwing good money after bad, averaging a losing trade, or whatever you want to call it.

So what of the future? If prices start falling, can't they just increase the size of the programs? Well, no. They can't.

The available pool of would-be buyers has largely already been exhausted. If someone hasn't accepted a near zero interest rate on a distressed property already, they're not likely to do so anytime soon. Additionally, the modification/moratorium games can only go on so long. After the banks offer remods, delay for months on paperwork and start to see 8 or 12 months of arrears build up, they will realize that not a penny more will be squeezed out of the mortgage. Foreclosure then becomes their best option.

But the real factor here is social mood. Populist anger toward the big banks is growing rapidly. It seems that every day we learn of one or more nefarious activities that went on between government, the Fed and the big banks. Backroom deals, non-disclosure agreements, acting with insider information, conflicts of interest, political favouritism, silencing dissidents, etc. Myself and a number of other bloggers were screaming from proverbial mountaintops that all of this was illegal and fraudulent. Nobody seemed to care at the time. They were scared. They had bought into the argument that "it had to be done... for the greater good."

But now, with the benefit of hindsight, the average person is starting to see what really occurred during those frantic days: a massive transfer of wealth from taxpayers to the financial industry. Yet the promised benefits - the unemployed getting their jobs back, investors getting their money back, etc - have not happened. In fact, as I pointed out in Part 3 of this series, the employment market continues to deteriorate. And now, gosh golly, the same financial firms are making money hand over fist and paying out bonuses like nothing happened! Taxpayers were duped. And they're pissed. President Obama's approval rating has plummeted faster than any president in the last 50 years. He makes speeches about "getting the money back from the banks" and literally nobody believes him.

An anecdote to illustrate the above: On occasion I post short rants on the CBC.ca comments forum below their articles. They have a feature that allows one to vote thumbs up or down on the comment. Usually I just post to get a feel for "the common man's" opinion. Being a libertarian in Canada doesn't often put me in good books of many, as Obama is likened to the second coming up here. But I posted in reaction to the recent plans for the Obama Administration to recover the TARP funds. I was harshly critical. I asked, "why such a focus on $800 billion, while the other $22.8 trillion in guarantees/swaps never gets mentioned?" My comment was met with unanimous approval. 88-0 last I checked. People aren't falling for this charade any more. And the Democrats are going to learn very quickly that if they don't start clamping down on the big banks, voters will clamp down on them next fall (yes, elections are only 10 months away).

The feasibility of introducing any more bailouts under these circumstances is nil. There will be violent rebellion before that happens again. Not only that, but the Obama Administration will face growing pressure to reverse as many of the bailouts as possible. They won't. At least not a significant amount. But the trend of social mood has sufficiently handicapped government's interventionist abilities. Likewise, it seems that a large portion of Americans have woken up to at least some of the Fed's activities. I see it likely that the Obama Administration will be held accountable for their actions as well.

Conclusion

A vast majority of the $23.6 Trillion in bailouts, swaps and guarantees has been directed toward supporting home prices. For the most part, they have failed. The natural course is quite obviously for home prices to continue declining toward levels commensurate with incomes and revenue generation ability. The expiration of many temporary "kick the can down the road" schemes, along with a flood of Option-ARM and Alt-A recasts, will significantly hamper bank balance sheets and eventually force further credit writedowns. Populist anger toward big bank favouritism will also limit the government and the Fed's ability to enact further legislation favourable to banks.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Themes For 2010 - 3 - The Economy

2010-01-11T14:22:00.000-08:00

For last week's discussion of the credit markets click here. In it we discussed the state of the existing credit base as well as the supply/demand equation for new credit and refinancings. In both cases, we found that credit was contracting significantly - even while government encouragement of accounting shenanigans has been allowing financial institutions to value their assets at [essentially] whatever they want.

Today, we turn our attention to how this above state of affairs is going affect the US and Global economy as a whole.

To calculate the GDP of a nation, most feel a fairly simple equation can be made: GDP = C + I + G + (E -M). Private Consumption, Gross Investment, Government Spending and Exports less Imports.

I'm not a particular fan of this metric. First, because essentially any activity, no matter how wasteful, counts as a net positive toward "economic activity." As a result, we are encouraged by government to undertake all sorts of wastefulness in order to keep up the appearance of prosperity. Second, economic activity which has been financed by debt counts just as much as does that financed by savings. All sorts of malinvestments result from crazy debt ponzi schemes. Should this really be considered "growth"? Third, GDP is too aggregative for my liking. It does not tell me enough about which part of the structure of production economic activity is being directed toward. Is money being spent on raw materials for the use of a factory owner who wants higher quality/more durable products? Or is it being spent by the military for the construction of bombs? The use of each have directly opposite impacts on our overall wealth, once the materials are used. GDP does not distinguish.

Return on our investments and the overall wealth of our society is what most readers here are concerned with, not some nebulous GDP number. So for our purposes, we will try to delve deeper into the various components of GDP for clues as to whether our overall prosperity will be on the rise, or will contract further.

It should also be noted that there is a wide theoretical disagreement on the cause of the current recession. Most of economic orthodoxy believes that an economy is always at equilibrium. There is no such thing as "growing imbalances" to worry about. This way, they can turn the entire economy into a mathematical model and determine the correct inputs and functions to predict the future. When the crisis erupted in 2008, plunging asset prices completely discredited this mathematical approach to economics. But the neoclassical economists have useful little terms like "rogue waves" and "tail risk" to explain crises. According to them, this completely random wave is what hit the economy in 2008. Nobody could have predicted it. It also necessarily follows that because this was just some irrational exogenous shock, now that it is over we should experience a rebound back to "trend growth"

While this is the orthodoxy subscribed to by many, there are literally thousands of economists who think it is total lunacy. Many of these economists instead choose to pay attention to debt levels and their effects on the economy, or the endogenous nature of recurrent financial crises in all economies. They focus on demographics, international trade and changing social preferences. The predictive record of these economists has been orders of magnitude better than the neoclassical economists and their mathematical models. Other than cognitive dissonance, it behooves me why one would continue to ignore the former in favour of the latter.

Before I bore you to tears, let me get started.

The Consumer

It is no secret that the consumer's large impact on the direction of the economy has, in part, been influenced by the easy availability of credit as well as a social incentive to go into debt for the purchase of material goods. Last week, we saw consumer credit numbers for November. Total credit outstanding continues to contract at increasing rates. It should be clear that this is a secular trend, after hardly dropping much below zero in the postwar period. Consumer attitudes toward debt have clearly changed. And we should be careful to assume that discretionary consumer spending will lead the economy out of recession as it typically has. This is not a typical recession, where producers overproduce, causing supply gluts, affecting employment, prices, etc. The cause is credit based. Too much of it. So while the cause was different than most recessions, the cure will also be different. Below is a chart of consumer credit outstanding. It contracted a further $17.5 billion in November - a new record rate of decline.

Of course, not all of America's consumption growth has been based on credit growth. Much of it has been based on genuine income growth. But that income growth has been falling of late as well. See below, the decreasing income and sales taxes collected.

Both real incomes and consumer credit have been deflating. This bodes ill for future consumption. Most would consider this a bad thing. But, as we can see in the chart below, the US (and much of the West) have been consuming more than they produce for a long time. So long, that we have gotten used to it. Over time, consumption must equal production. And it appears that truism is finally playing out.

(chart from Jake at EconomPic Data)

He explains,

The difference between GDP (what the U.S. produces) and Gross Domestic Purchases (what the U.S. purchases) is net exports. Thus, the charting is easy, but the result of the chart is rather astounding. The net level of purchases over production peaked at more than $2500 per person (that is literally $2500+ in a single year for every man, woman, and child within the U.S.) in September '06. This has "collapsed" to "only" $1150 a head, but that $1350 less that each person in the U.S. has been able to purchase (without producing) is a real decline.

So where does that leave us? It leaves us with entire generations (starting with the baby boomers) that believe it is the norm to purchase more than one produces

Instead of lamenting this, I suggest we embrace it. As we do so, jobs will be lost in service industries and gained in manufacturing. This is a transition that could occur fairly quickly if wages were permitted to become more flexible. Americans have lost a large portion of their competitive advantage. As such, they must be willing to accept lower wages. Over time, this competitive advantage may be regained and wages will rise with it.

Employment

The breathtaking rates of job losses we saw throughout 2008 largely abated in the spring of '09. But contrary to the spin, the employment market has not been improving. It simply stopped getting progressively worse. (ie. the second derivative was improving while the overall picture was still deteriorating).

Last Friday, we received the nonfarm payroll data for December. The headline establishment survey number showed an additional 85,000 job losses. But the more revealing number comes from the household survey. There, we learn that 843,000 stopped looking for work and fell out of the workforce. That makes for a yearly total of 3.5 Million that decided to stop looking for work. Some of these are discouraged; some are back in school; others might be boomers retiring. But a large majority of them will be back looking for work as soon as there is demand for their services and this will keep a lid on wages for many years to come. Add that to a gradually growing population and we are painted a very bleak picture.

Companies may have stopped firing workers en masse, but they are nowhere near ready to begin hiring.

This structurally high level of unemployment does not portend well for the "V-shaped recovery" thesis.

The silver lining in this may be that as hours worked and labour costs have been falling, output has fallen less. This means that productivity has been increasing. People are having to work harder in order to keep their jobs. Businesses have likely also tried to eliminate wasteful spending. This is always a good thing.

Investment

We become wealthier by learning how to produce more with fewer resources. We also "accumulate" capital goods that are able to produce more of what we want. As people die, others inherit these capital goods and knowledge at no cost to themselves. As a result, every subsequent generation is wealthier than the previous. The only way to reverse this trend is by destroying capital goods. This is typically achieved through war, but can also occur by not sustaining equipment and allowing it to fall into disrepair.

In much of the postwar period until the early 80's, nonresidential investment was a leading indicator for the economy. But then consumers began to leverage themselves and consumption growth was the main driver for the economy out of recessions. I believe that we will be experiencing a return to the previous order, as consumer credit remains constrained for the first time in decades and the trade balance comes back into line.

Unfortunately, investment has been taking the brunt of corporate retrenching. But as wages remain low, and productivity rises, large investment projects may become more feasible in coming years. This may not be the key to a recovering GDP, but it is a key to an improving economy. Investment has a positive multiplier effect on future rates of growth. Debt fueled consumption and government spending typically have a negative multiplier effect.

Conclusion

We are most likely (as of June '09) in the midst of a technical recovery as defined by GDP. But this masks the rot underneath the surface. Consumer credit and income growth are contracting. As such, personal consumption expenditures will likely remain depressed for some time. Short term gimmicks like "cash for clunkers" and homebuyer tax credits may provide incentives for consumers to delay their deleveraging, but the cost of the programs add to the overall debt burden, which needs to be paid with interest. High debt servicing burdens hinder our ability to invest. In the long run, these programs are detrimental to GDP - even though they may provide relief in the near term.

Structurally high unemployment will likely persist, as those who have recently fallen out of the workforce will join it again upon improving job market fundamentals. This will serve as a drag to economic robustness, but should keep wage pressures low for a considerable amount of time. Declining wages will increase productivity and likely bring about a revival in the US goods-producing industries that have shed jobs for 3 decades.

The picture I have painted above is very deflationary. Combined with contracting credit markets, valuations of financial assets should decline to reflect their weak earnings potential. I will discuss the implications of a rebalancing economy and contracting credit on asset markets later this week.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 02.10

2010-01-10T19:53:00.000-08:00

Another week of gains for major market averages to start the year. Volatility is low. Fear is non-existent. An array of 12 analysts polled by Bloomberg all expect gains for stocks in 2010. The most "bearish" of all these analysts expect gains of 10% on the year. Have these people learned nothing of the perils groupthink and recency bias can bring?

I can only equate today's long grind higher - behind the veil of steadily weakening fundamentals and unacknowledged credit market deterioration - as analogous to that of what we experienced toward the end of the bull market in '07. See the charts below for a visual on that analogy.

First, here is today's market.

Next, here is the '06-'07 advance. Following this grind, while very few even conceived of anything other than perpetually higher prices, a few subprime mortgage lenders "all of a sudden" went bankrupt. Following a fairly substantial two day shock, the markets continued higher. But they were never the same.

Just a short blurb today. I'll have something more cohesive later this week.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Themes For 2010 - 2 - Credit Markets

2010-01-07T07:56:00.000-08:00

The Great Credit Crisis of June '08-March '09 was triggered two years earlier by debt ratios that had exceeded the economy's ability to service them. Quite naturally, this was first felt in areas of the credit markets that were serviced by the weakest incomes, ie. subprime. As homebuilding activity reacted to oversupply and contracted, rising unemployment in this and related industries put these marginal borrowers into default. The ensuing foreclosures pressured home prices, putting large numbers of "homeowners" underwater on their mortgages. This led to more foreclosures and the cycle became self-perpetuating.

Stresses on the balance sheets of major banks started to become apparent in late 2007. Interest rates were slashed. The pyramid nature of credit derivatives was exposed shortly thereafter. Ultra-leveraged hedge funds blew up, forcing liquidations. Panic set in. Losses had exceeded 10% on (and off) global bank balance sheets. With leverage of 10:1 or greater this meant one thing: bankruptcy. For the entire financial system.

This is not the version of events described by policy makers and the banks themselves. They prefer to pin blame on certain people involved: typically regulators, politicians, borrowers, mortgage brokers, fund managers, irrational investors or anyone else that deflects attention from the simple mathematics of what happened. Deflecting attention is so easy, because by blaming people rather than a faceless structure, partisan politics can evoke human emotions. This is how it becomes possible to create a media hoopla over hundreds of millions in banker bonuses, while trillions in guarantees are simultaneously shoveled into the pockets of agencies like Fannie and Freddie with nary a peep. One problem evokes ideological debate, while the other (10,000 times larger) has received bipartisan support for decades.

I trust that my readers are intelligent enough to see through this charade. Once this bickering is completely ignored, the simple facts of what happened and what our present situation entails for the future become totally transparent. Our job here is not to pin blame on Democrats or Republicans for the current state of affairs or past events. Our job is to simply acknowledge that credit flows have been the primary determinant of the business cycle and of major asset markets for decades. By following some indicators of these credit flows, we should then be able to determine which part of the business cycle we are in and what that should mean for asset prices going forward.

Credit Markets

The existing debt stock in the US, inclusive of government, consumer, financial and corporate debt is estimated to be $53 Trillion. This excludes unfunded liabilities and credit derivatives. Total US GDP was $14.2 Trillion in 2008. This gives total debt 370% greater than GDP, illustrated below.

A larger portion of our incomes are required to finance this debt as the ratio increases. This has been ameliorated by falling interest rates. As rates have fallen and debt has accumulated, the overall servicing burden on the economy has remained somewhat constant. 10-20% of our incomes go toward debt servicing. When interest rates started falling in 2007, the servicing burden eased toward the lower band of 10%. Incomes were freed to be spent or saved elsewhere. This has created a temporary resurgence in economic activity. The reason I suggest this is temporary, is because interest rates are primarily a market price for money. As economic activity accelerates and people start to believe it will continue, the cost of funds rises. Because of interest rate convexity (changes in rates have greater impact the lower they are), even a slight increase in rates will have disastrous consequences. At a current rate of 4% for all debt outstanding (derived from the Lehman Agg Bond Index), we are back to using 15% of our incomes for debt servicing. Should rates rise to 6%, we'll need 22.3%. I highly doubt an economy can grow with debt servicing ratios above 15%. It crimps our ability to invest in productive capacity and to replace old and obsolete capacity. It is like a tapeworm, sucking the life out of the patient.

There are a number of ways out of the above conundrum. Historically, when interest rates have fallen, the nominal debt level has been much lower (relative to output), resulting in a debt servicing burden far below 10%. This has encouraged huge amounts of investment, and the economy has grown into its debt burden. But our starting point is far more problematic this time around. Government spending and consumer spending without increased tax revenues or incomes respectively, do nothing but increase the overall debt burden. It is investment in productive capacity that is required. As I'll show, this is not yet happening.

The other way around the situation is for debt to be retired, ie. paid back at an increasing rate or defaulted on. This appears to be the market's preference, but the various legislative and executive actions taken since the onset of the crisis have been direct attempts to prevent this from occurring. This has had the effect of masking the market values of some credit instruments. Like morphine, this does not eliminate the disease. It only buys time for the economy to grow into its debt burden.

If loan losses had ceased and money was being poured into investment, I could see the argument being made that the recession was over. Considering the credit crisis was caused by these very problems (bad loans piling up on bank balance sheets), and with aftereffects like the falling stock market and rising unemployment being mere symptoms, logic would suggest that the disease would at least slow down before we claimed victory. But loan delinquencies in nearly every category continue to deteriorate at or near the same rate. See the Fed's delinquency report here. Notice that real estate loans, both residential and commercial are falling delinquent at an accelerating rate all the way through Q3 - almost 1% of loans per quarter. C&I, Agricultural and Lease delinquencies are rising as well. Only the consumer loan category has shown any signs of abating. It has merely stabilized at all-time highs.

The increasing stresses on residential mortgages should come as no surprise to anyone. 1/4 of all mortgages are underwater, ie. the price of the residence is worth less than the mortgage. Half of that group are 20% or more underwater. (source: First American CoreLogic).

So why aren't the banks announcing writedowns on these bad loans? First, they're not foreclosing on them. Various foreclosure moratoria have prevented banks from foreclosing. And the modification efforts have stalled hundreds of thousands more. Second, banks have been given free reign to value their assets at whatever they like in the accounting process. But the losses still exist, and they will need to be taken. This is one reason why we hear of "banks not lending money." Their balance sheets are so impaired that they can't.

The above is a chart of Allowances for Loan and Lease Losses (ALLL). With the enormous inventory of delinquent loans, this metric should be rising in anticipation of the writedowns. But making provisions is not free. Capital needs to be freed from elsewhere. This crimps the banks' profits and therefore their ability to make huge bonus payouts.

Regulators and policymakers have been telling us that the banks' health is improving. This is a lie. Not only are ALLL at all-time lows in the face of all-time highs in loan delinquencies, but the too-big-to-fail banks that caused so much systemic risk in 2008 are even bigger today. If I were a cynic, I would think that they are merely keeping up appearances to justify enormous end-of-year bonuses.

One argument to the above weakness I have heard suggests that it is all rear-view thinking. The banks are being recapitalized with favourable lending spreads and their leverage ratios are falling. This is true, but in the face of what? See below.

Notice the lull in resets during 2009 as subprime mortgages became less of an issue and Option-ARM resets hadn't quite got going yet. There will be no such reprieve in 2010. A wave of recasting mortgages will hit banks this year. And with such high numbers of these borrowers significantly underwater, a large percentage will end in foreclosure. In most cases, the quality of these loans were just as bad as their subprime counterparts. Negative amortization loans, teaser rates, and various "pick-a-pay" loans are all included in this category.

A few things to note from the chart above. First, it is two years old. So the number of recasting Option-ARMs may be slightly overstated as some have been already walked away from, foreclosed, or renegotiated. However, one should also note the vintages. Option-ARM mortgages typically recast every 5 years. So the influx of such recasts in 2010 suggests that their vintage is primarily 2005 - right near the peak of the housing bubble.

Another important indicator for the overall health of the credit markets can be found in refinancing activity and new credit creation. By all accounts, these metrics are declining rapidly.

The Mortgage Bankers Association provides weekly data on purchase applications and refinance activity. (Chart courtesy Calculated Risk)

There was a brief blip in activity earlier in the year, but starting in October, mortgage applications began falling off a cliff. Indeed, there are many buyers who have simply paid cash for distressed properties and these will not show up here. But their overall impact is still fairly benign. Keep in mind that this index is moving lower despite a large tax credit for homebuyers and massive efforts to refinance existing mortgages (HAMP).

Evidence of weak credit expansion can also be found in the latest Fed Senior Loan Officer Survey. While demand for loans and willingness to lend appears to have risen appreciably since the spring, a majority of respondents still suggest that demand is weakening while lending standards continue to tighten.

Some entities, however, have had an easier time finding access to credit over the past year. Many large multinational corporations have managed to take advantage of the Fed's asset purchase/swap programs by refinancing their obligations and restructuring the duration of their debts. Real Estate Investment Trusts (REITs like SPG and KIM) are perfect examples of this. Saddled with debts owed to major investment banks, mall owners and the like were bordering on bankruptcy. But by stashing these debts on the Fed's balance sheet through the TALF program, the REITs have managed to rollover their near-term obligations while the IBs have been book-runners for numerous equity offerings, reaping major profits in the process.

Although this could be considered positive to those hoping their stocks don't become worthless (like that of GGP, for example), I see it as more malinvestment which needs to be liquidated at some later date. It kicks the can down the road. Business prospects for these companies are bleak. Even as their current status quo was rescued, their ability to service these future debts was rapidly weakening. Retail vacancies rose from 12.9% in 2008 to 18.6% in 2009. Meanwhile, asking rents have fallen 8% over the past year. This is the primary revenue generator for mall operators. When the malls were purchased during the leveraged buyout (LBO) craze of the '04-'07 years, the prospectuses for the new debt issues projected steadily appreciating rents and constant-level demand for square footage. This has now proven to be wildly optimistic, yet the Investment Banks feel it prudent to continue extending them credit at low rates.

If the above sounds like moral hazard in action, you would be correct. The Investment banks feel like they will always be able to throw their losses upon either the Fed or taxpayers. So there is no risk to them in extending high-risk credit at low-risk rates. This may buoy the stock prices of banks, but it is a net negative for the economy and the credit markets as a whole. Obviously bad loans being extended is not a recipe for recovery. It is a recipe for disaster. One would think we should know that by now.

Conclusion

On the whole, credit markets have not recovered. In fact, in many areas credit quality has continued to deteriorate unabated. A pending supply of low grade mortgage recasts, along with an overhanging inventory of underwater mortgages will likely force a continuing deterioration in loan performance and further house price declines. Despite accounting shenanigans that allow banks to value their assets at whatever they like, banks' lending ability remains constrained, while the ability and willingness to borrow is also under pressure. The overall amount of debt outstanding is also constraining the economy's ability to lend its way out of the recession. Even with historically low rates, the high level of debt gives us a servicing ratio that constrains our ability to invest in productive capacity.

I will detail what the implications of this are for the economy in Part 3.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Themes For 2010 - 1 - Review of '09

2010-01-05T10:21:00.000-08:00

For much of 2009 I was proven to be too bearish on asset markets. I have learned a lot from this experience. That is the entire purpose of this blog. For me to learn. That is how it began in late '06 when I simply wanted to organize my thoughts and decided to publish them online. I have left all my previous learning experiences online, in part hoping that others can learn from them. But mostly because I want my past failures to remain inescapable. I am cognizant of the various forms of psychological bias (recency bias, confirmation bias, cognitive dissonance, etc). And I'm determined to mitigate them while expanding my knowledge in an industry typified by those with a heightened sense of self-importance. Modesty is either willfully accepted or forcibly applied.

This is the fourth year in which I offer my thoughts. Previous year's themes can be seen here: 2009, 2008, and 2007.

I am typically as critical of my own performance as I am of others'. But that aside, my overarching theme of debt deflation/deleveraging and its adverse consequences for asset markets has been proven correct in spades, even while that sentiment was deeply unpopular in the beginning and widely thought to be "impossible" in many academic circles.

Lastly, some context to last year's themes. At the end of 2008 we had just endured two massive plunges, bailouts and confidence campaigns by governments everywhere. Markets had rallied 25% from their November lows. Most concluded that the bottom was in and would not be revisited. In the first two months of '09, most of my themes were playing out according to plan. Markets plunged 30%, making new lows. The recession was deepening. People were getting scared. Riots and protests broke out in much of Europe. I had forecasted a "false recovery" of sorts. But I thought it would be brief. August was as long as I thought it could last.

I had fallen victim to my own success. Self-attribution bias. So it was a tale of two seasons for me. January to March vs the rest of the year. Shockingly accurate and then wrong.

In last year's themes for 2009 post I had derided the popular bullish projections given by most analysts. 1200, 1300 by year-end. Pft! By the end of the year, they were far closer than my bearish calls. But with the early year plunge, most had retracted their projections. So if one listened to the bulls a year ago, would they have held on the whole way? Hard to say.

Here are my Themes for 2009: (this year's thoughts in bold)

- Government attempts to "get credit moving again" will fail. The credit contraction (deflation) will continue even as governments and central banks do everything within the law (and even some outside) to encourage hyperinflation -- Half point. In some areas credit came back. In others, it has continued to deteriorate. And others still, it has been manipulated. I was right about the lawlessness bit.

- Crumbling corporate earnings as consumer psychology moves away from the "gotta have it now" mentality to "it can wait until next year" -- Airball. Consumers have changed, but only slightly (when don't they?). But corporate earnings benefited from cost-cutting, strong exports and low interest rates. Huge miss.

- Municipal and State bankruptcies requiring federal bailouts in the US -- This is the second year I've made this one of my themes. It continues to play out, although slower than I expect. Half point again.

- Skyrocketing unemployment. Official figures to reach 9% or higher in the US. -- Swoosh. That one seems almost too easy, but was far from consensus a year ago.

- Worldwide social unrest or even war as currency collapses, unemployment and falling asset prices shake people's faith in their governments and scapegoats are made of traditional enemies -- riots in Europe, Thailand, Iran were not what I had in mind. Miss.

- Plummeting stock markets worldwide with losses of 50% or more in major indices as hype over President Obama wanes -- Obama went from 70% approval ratings to 48%. The market did not follow as I expected. Miss.

- A wave of bankruptcies in retail, restaurants, airlines and financial services. Nationalization of the politically well-connected --- Small business bankruptcies rose 44% for the year. Restaurant activity contracted all year. We know what happened to the banks. I'll take a point here.

- A continued strength in the US Dollar vs most other major currencies as European infighting escalates -- Finished down 3%. Euro tensions indeed growing. Miss.

- Declines in the price of gold but continued relative outperformance to other assets and most currencies -- Half point. Price up and outperformed.

- Large declines for Canadian real estate, notably in bubble areas of the west and prairies -- Again, worked well early. Fell apart thereafter. Miss.

- Social "witch hunts" for those responsible for the common plight. Multiple scandals uncovered. Persecution and enormous tax increases on the extremely wealthy -- Not as fierce as I expected, but I'll take it. Tea Parties, windfall bonus taxes, populist anger growing toward bankers. Insider trading rings, hedge fund ponzi schemes, tax haven busting.

- An increased focus on the family, on close friends and "time" in general -- Too interpretive to take credit either way. I see it slowly evolving.

As I always disclaim, "some of these will be proven correct, others will prove laughably false." While I give few absolute targets, and thus many are interpretive, I lean toward the critical side. I'd rather learn something from going too far or not far enough, than simply pat myself of the back.

In some areas, I have become even more bearish than I was at this time last year. In others, the unfolding events have me convinced that some legitimate progress is being made. I will surely expand on these thoughts, sparing no ink over the next week or so. I will cover the current state of the credit markets, the economy in general, followed by the impact this will have on asset markets. Stay tuned!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 01.10

2010-01-03T12:01:00.000-08:00

Note: I have changed the name of my weekly update to "market update" from "technical update." As this will be my primary communique, it will have less of a technical analysis theme to it most weeks. This way, I won't feel obligated to post charts if nothing much has happened. And I'll be more able to branch out into other themes if attention warrants (silly really, it's my blog, I can always post whatever I want). So if you're not a TA type and have ignored my weekly columns hitherto, perhaps it will be of more interest this year.

Ironically, however, today I will just post a few charts. I'll have more big picture stuff later this week.

The last 30 minutes of trading in 2009 saw some heavy volume selling that essentially wiped out the previous 2 weeks' low volume gains. The markets still look overextended and tired. But as long as market participants are willing to ignore the creaking fundamentals underpinning these prices, they can remain where they are. I see social mood rolling over slowly as it has for months now, but it seems to be taking various groups of people with it separately. Those in the financial industry still seem to be euphoric in their expectations, while the masses are downright apocalyptic. This is the source of the sentiment dichotomy many are hearing about. Every couple of days a sentiment report will be released giving complete opposite readings. Either extremely bullish or extremely bearish. It's funny to watch.

So whether the end of year selloff meant anything or not largely depends on who is going to win this battle. Populist anger is growing toward the ineptitude of "reform" efforts. I continue to be shocked and amazed at how blatantly the efforts are designed to preserve the status quo - and in many cases even to encourage the same excesses that caused the crisis (eg. raising the cap limits for Fannie and Freddie, authorizing $4 Trillion dollars for future bailouts). I don't even know how to respond to something so idiotic. Should I be angry? Should I laugh? Should I bother to explain why it's a bad idea? Seriously, am I even going to write an article saying that increasing the cap limits for Fannie Mae is potentially disastrous? Would I spill ink explaining that drinking ammonia could be harmful to your health? The paralyzed reaction I've had toward this is something that I've seen in a lot of people. But I've noticed that a number of dissenting high-level officials have started coming forward. The backlash is growing. And it will win eventually. The banks always lose in the end. Banking has been around for millennia, yet few banks have survived a century. It is their nature to fail when populist anger toward their activities rises. Now some charts.

The S&P sold off to the upper band of its previous trading range. This could be supportive ahead of an early year push. More support resides around the 1085 level. Anything below 1060 looks like it would severely damage the integrity of the longer term charts.

The US dollar was halted at its 200 day EMA. There is big time support surrounding 76.50-77. If it can close a fair bit above its recent highs, I think it is lights out for the dollar bears.

Internals are mixed. But the Put/Call ratio hit a new low for the rally and appears to be putting in a reversal. Lower readings reflect more call buying and thus more optimism.

Good luck in 2010!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Tick Tock

2009-12-30T15:58:00.000-08:00

Not much to post of late. I'm summoning my energies for a series of articles reviewing the past and looking toward the future. I always look forward to these articles. They allow me opportunity to clear away the poor analysis and build upon the good.

In the meantime, let me entertain you with a poem, courtesy of the Financial Times' deputy editor Martin Dickson. If nothing else, the appearance of this now, after such massive recoveries in asset markets confirms the Socionomic/Elliott Wave thesis of a secular bear market in social mood. A secular bull market - like that during the S&L crisis or LTCM - is typically quick to forgive bankers for losses they have incurred to all. A year after the carnage and it seems that antagonism toward the finance industrial complex grows more rabid by the day. As it should. Pass this on to your friends.

The Bankers Who Wouldn't Say Sorry; A Cautionary Tale

(With apologies to Hilaire Belloc)

There was a time when naughty boys
Would have to forfeit all their toys,
And go to bed without their food
To force a new, repentant mood
Upon the wretched little toads,
Who flouted our great social codes.

Nor was blind arrogance a trait
That parents liked to inculcate.
They had regard for social graces:
Not for their offsprings’ haughty faces.
A beastly child engaged in folly
Would surely have to say: “I’m sorry!”

But now we live in debased times,
Sans punishment to fit our crimes
Our moral compass has got lost,
Or on the rubbish heap been tossed.
As in this cautionary tale of bankers,
Who came to look like social cankers.

You will all know the basic story,
In all its venal details, gory.
Of how a bunch of peerless clowns
Despite degrees – from Yale to Brown –
Behaved like schoolboys in the lab,
When teacher’s gone to smoke a fag.

Exuberant beyond all reason
(For this or any other season)
Fired up by dreams of starter castles,
Sardinian yachts and vineyard parcels,
They built themselves a strange device –
A ticking bomb, to be precise.

The trouble was they did not know,
It was a bomb ’twas ticking so.
They thought it merely marked the beat
That called them to stay on their feet
And dance away – to really bop –
To music that would never stop.

At last the bomb it ticked no more.
Instead it gave a mighty roar
Like some avenging finance demon,
And destroyed RBS and Lehman.
That made the bankers wail and yelp,
And rush to teacher for some help.

Faced with the imminent demise
Of all world banks of any size,
And thus of global finance too,
The state bailed out this sorry crew.
But were they grateful? Not a jot,
This arrogant and greedy lot.

“It wasn’t us,” was their refrain.
The regulators are to blame.
They failed to prick our growing bubble.
They are the cause of all this trouble!
And China too, and central bankers,
Who failed to give us decent anchors.

“And while we’re at it, let’s include
Those nasty hedge funds, brash and crude,
We may have lent them stock to play,
But not to short poor banks at bay.
We’re sad events turned out this way
But not to blame; nothing to pay.”

Their minds so tainted by success,
They could not see their gross excess
Had played a very major role
In this colossal world own-goal.
Amnesia can be a sickness,
But this denoted arrant thickness.

Their attitudes were so repulsive
The public backlash grew convulsive,
And dimly seeing that their wages
Just might be threatened by these rages,
Self-interest prompted some to say
“We’re sorry” – in a muted way.

But actions more than words do speak
And their repentance was skin-deep,
Just like the artful crocodile
Shedding fake tears beside the Nile.
(And while we’re thinking of the zoo,
A vampire squid swims into view.)

“It’s plain,” they said, “we do not need
Tough regulation. Do not heed
The cries of all those sad dimwits
Who want to break us into bits.
Our little hiccup now has passed.
Back to the gravy train – and fast!

“To moral hazard give no thought!
We see no need to get distraught.
Please rest assured God’s work we’re doing
(It’s merely taxpayers we’re screwing.)
The Lord to us has sent a sign:
Monopoly profits are just fine.”

How could these people fail to see,
Their debt to all society?
The short answer must surely be
A banker’s mind is conscience-free.
They grab the profits of risk-taking,
Leave us the losses that they’re making.

The politicians fumed and fussed,
But they were well and truly stuffed:
The banking system had to work
Or jobless men might go berserk,
Victims of a growth disjunction
Piled upon finance malfunction.

In short, the banks – still big and burly –
Had got them by the short and curlies.
So their response was rather vapid,
And not decisive, hardly rapid.
Bankers returned to their old ways,
Assured a life of Christmas days.

Too big to fail, too hard to tame,
They returned to their former game:
Taking risks of insane folly,
To stuff their pockets full of lolly,
Untroubled, with the certainty
Of a taxpayers’ guarantee.

It would be good to end this story
In a nice blaze of moral glory,
Like Hilaire Belloc’s clever tales
Where evil-doing always fails.
Alas, the only moral here
Is bankers just themselves hold dear.

But there’s a price we all will pay
If politicians won’t display
A little courage and crack down
Upon these unsafe, grasping clowns:
Another bomb is being built,
By bankers with no sense of guilt.

It’s ticking now, will louder tick
Unless we stop it, fast and quick.
For mark my words, believe this rhyme,
It will go off in five years’ time.
You’ll hear no end of sturm and drang.
When it explodes with a loud BANG!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Happy Holidays

2009-12-24T08:53:00.000-08:00

I'm taking a much needed few days off over the holidays. Thus, there will be no weekend commentary this week.

I'll be doing some in depth posting over the next few weeks, so stay tuned!

Let me wish my readers a happy and safe holiday season.

Best,

Matt

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 49.09/European Woes

2009-12-20T11:50:00.000-08:00

Another week of gains for the US dollar was met with general indifference from equities around the world. Commodities also turned their cheeks to the currency market action, reminding us that correlations long-adhered to can break. Last week we were expecting a bit of a retrace in the dollar index and commodities which would allow for equities to put in new highs. That is still my working assumption. Yet with option expiry hangover, combined with 2 weeks of very low volume upcoming, I suppose anything is possible.

The weakness in the Euro is being blamed on sovereign concerns around the periphery of the EMU (European Monetary Union). Specifically, Greece, Ireland, Spain, Portugal, and Italy are the focus of most observers. But bear in mind that these issues are not somehow "unforeseen" as most imply with their surprise. Greece did not accumulate a 12.4% budget deficit overnight. Nor did Italy find itself with a total debt 1.14x its GDP. These have been very long-term problems. I, as well as many others, have been pounding the table with the untenability of this situation for a long time. And I ruminated back in the spring that the next round of this crisis would originate in Europe.

Social mood may have turned with the recent attention to these long-standing problems. And we know the kind of contagion that will result should this escalate. Let us not forget the issues facing Ukraine, Hungary, Romania and the Baltics. All major european financial institutions have exposure to these toxic emerging markets in addition to their hidden exposure to US subprime CDOs.

Below is a table from STRATFOR that details each Eurozone country and their debt burdens. Remember that the Maastricht Treaty forbids any country from surpassing a deficit of 3% of their GDP. Nearly every nation has completely ignored this. Germany's supposed new "conservative" coalition threw in the towel this week, suggesting they would escalate their deficit spending. If nothing else, this proves the uselessness of international regulations. When push comes to shove, any nation will look after their own asses first. It is this mentality that will, in my opinion, eventually lead to the breakup of the EU and the dissolution of the EMU. This process may have begun already. Or it may be dragged on for a decade or more longer. But the endgame is already written. A Euro will eventually be worth less than the "lowly" US dollar.

I recommend readers monitor CDS spreads closely as an indicator of the seriousness of these problems. Over a week ago, when stories started breaking about Greece's problems after a Fitch downgrade, their CDS premiums shot up to 232. Since then, Greek officials have said there is "no possibility" of EMU withdrawal or sovereign default. Yet, the assurances have not seemed to gain traction. Greek CDS now stand at 279. Intraday top movers in CDS premiums can be found at CMA Market Data.

Below is a chart of the Euro's performance. This makes 3 weeks straight of declines and essentially wipes out any of its gains from the previous 3 months. What's done can be undone in short order. Equity speculators should take note.

I am also including a number of charts from eastern European currencies relative to the Euro. Last winter, some of these currencies began blowing out. But assurances from the IMF managed to ease the fears - for a time. At issue are loans made in these countries (Latvia, Poland, Czech Republic, Hungary, Bulgaria, Romania, Ukraine, Russia) but denominated in other currencies (primarily the Euro, Swiss Franc and US Dollar). The availability of loans at very low interest rates; prospects of continuance in the decade long appreciation of local currencies; and eventual induction into the EMU were the primary forces driving asset bubbles in these countries. When the bubbles popped along with asset bubbles all over the world in 2008, their central banks began printing money to "stimulate" their economies. This had the effect of depreciating the local currencies and thus increasing the debt burdens of those who borrowed in foreign currencies. Default prospects increased, jeopardizing the solvency of their western lenders. This is where the IMF stepped in and gave some very vague guarantees with some very unknown preconditions. Most likely they instructed the eastern central banks to stop printing and told their finance ministries to instead introduce austerity measures. I wonder how long populist oppositions will stand for the rising unemployment that goes along with this? At what point will they simply say, "to hell with the western bank's losses, we default." Or, "to hell with the EU and the Euro, we're inflating our way out!" Either way, losses will eventually be realized on these malinvestments.

Hungarian Forint/Euro:

Polish Zloty/Euro:

Russian Ruble/Euro:

Ukrainian Hryvnia/Euro:

There are also potential issues in Bulgaria and Latvia, where currencies are pegged to the Euro. They were both scheduled to enter the EMU by 2012, but that now seems unlikely. If they decide to forego entrance, their pegs break and any loans made are essentially wiped out.

Ambrose Evans-Pritchard has another Euro-skeptic piece detailing the unsustainable nature of these austerity measures in southern Europe. Enduring deflation is the natural way out of things for the US, UK, Canada and essentially any country whose debts are largely domestically originated. But when this path is dictated by foreigners who got you into the problem in the first place, I can see how the political impossibility would lead to its failure.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Response to Robert Murphy

2009-12-14T09:17:00.000-08:00

Robert Murphy of the Mises Institute had a good article out this morning titled, "A Case For The Inflation Camp." He talks about why he expects consumer prices to continue to rise. I recommend my readers have a glance over this.

As my readers know, I have a different take on matters. Below is the brief response I left in the comments section of Murphy's post. Feel free to weigh in with your own take.

The primary arguments in favour of deflation look less at consumer prices and more at asset prices, bank lending, debt/income or debt servicing ratios, demographics and social revulsion of excesses.

Many things can contribute to consumer price changes. This year we had a very large drop in inventories and capacity utilization which eased downward pricing pressures significantly in spite of falling consumer demand and reduced credit availability. We also had commodity prices rising from leveraged speculative bets by hedge funds.

The first two are like bullets in a six shooter. They can only be used once. I suppose the commodity speculation could be considered the very early beginnings of a "crack-up-boom," but other than gold, there seems to be little panic buying in the more "emotional" of these commodities (grains, energy). And it is precisely this fear (OMG, I might not be able to feed my family, "I'll take 10 sacks of rice!") that characterizes the CuB.

Until I see that kind of fear and still no willingness to quash it from central bankers, speculation of runaway inflation is premature.

One thing we can likely all agree on is that deflation "should" happen. We have too much debt and asset prices are too high to be supported by our incomes. And the easiest solution to this problem for those without access to a printing press (small businesses and consumers) is deleveraging. Considering they compose the largest sectors of the economy, their actions will determine the overall outcome.

Technical Update 48.09

2009-12-13T11:53:00.000-08:00

Most major stock indices were flat around the world last week, even as the US dollar continued its push higher and commodities sold off significantly. The followthrough on the US dollar was something we were looking for last week as a key to the topping process we have been tracking for months. It has traced out a very nice looking 5 waves up (the Euro has done the inverse) and should now retrace that move in 3 waves down.

The blue chip stock indices have been the most resilient over the past few months as the FIRE sector (Financials, Insurance, Real Estate) has lagged behind considerably. It was a credit based bubble that popped in 2008 and it has been a credit based recovery. To me, this suggests that the overall structure of the economy has not changed. Therefore, weakness in these areas, much like during the 2007 rally, should be considered a leading indicator for the overall market. I am expecting the major indices to make marginal new highs next week, as the US dollar retraces but fails to make a new low. This should be the final non-confirmation prior to embarking on a monumental decline. This likely sounds like a broken record by now. We've been monitoring this process for months. Bears are now, to be sure, tired of waiting. I know I am. But to keep things in context: after a 53% rally in 6 months, the S&P 500 has rallied only 8% in the 4 months from August to the present.

The past few weeks have seen painstakingly quiet markets, reminiscent of John Kenneth Galbraith's account of the 1930 rally which he described, "as placid as a produce market." Despite the historical context of nearly all major bear markets retesting their lows to some degree, I have been able to find few market analysts/pundits willing to entertain that possibility. The idea of going back to where we came from is as preposterous to most now than dropping below Dow 10,000 was to most in 2007. Sure, many are expecting a correction, but little more than 10-20%. This is an incredible amount of confidence considering we have rallied more than 65% in just 10 months. I'd wager a guess that this is unprecedented confidence. Below is the Bull/Bear ratio, as determined by the Investors Intelligence survey.

The S&P 500 has traded within a 3.5% range over the past 5 weeks.

Crude oil has an opportunity to extend to the downside. Any continuation below Thursday's low substantially damages this chart.

As previously mentioned, the Euro has put in its most significant decline since June. A fairly swift retrace back up to 148-149 should occur prior to a resumption of the downward trend.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Sovereign Default Risk Puts Floor Under US Dollar

2009-12-09T11:35:00.000-08:00

Note to readers: The following post originally appeared at Examiner.com. I have recently taken a position as their Canadian Economy writer. I will still be contributing to Futronomics, but some of the articles will be cross-posted. You will notice a difference in the style of writing in such articles, but I pledge to stay true to the spirit of my work to date. Naturally, the work will be a little more "Canada centric," but most will still have relevance for my American readers. Feel free to visit my Examiner page often and subscribe to my posts if you wish. I am paid minimally based on article views, subscribers and comments. However, this is more of a resume boosting endeavor, so we will see how it goes...

When Dubai World, the state backed infrastructure company, warned of its inability to meet obligations without assistance two weeks ago, some analysts noted that it had the potential to spark fears of other susceptible nations to do the same.

This week, markets have been tentative after rating agencies confirmed those fears with downgrades in Europe.

Greece, widely known to be the weakest among major EU economies, was the first to be given a downgrade by Fitch. Its rating was slashed to BBB+ and reiterated that further cuts may be in the offing. Standard and Poor's also expressed heightened caution a day earlier, stating that they have a "negative" outlook on the future direction of ratings. Ratings were also lowered on Greek commercial bank debt.

Ratings downgrades are considered significant events because certain investment institutions (such as pension funds) are only allowed to invest in debt that is considered investment grade. A downgrade could force selling of government bonds, pushing interest rates up and exacerbating the problems.

Fitch noted that the historical record of fiscal management in Greece had been poor and that they are, "not convinced that the substantive pension reform and other measures necessary to contain public spending pressures and broaden the tax base will be sufficiently strong to materially reduce debt."

Credit default swap contracts (the cost to insure against default) on Greek sovereign debt has risen substantially over the past two days to 232 basis points.

Spanish sovereign debt risk also rose, as Standard and Poor's put the nation on "watch negative."

Fears of greater contagion have put higher risk premiums on almost every European nation. As a result, the euro has fallen by 3% against the US dollar in the last week. Over the past few years, the US dollar has strengthened when risk aversion increases. The reaction could prove detrimental to other currencies like the Canadian and Australian dollars, which have also benefited from risk seeking investors borrowing money in the US and taking it abroad.

Willem Buiter, professor at the London School of Economics, and incoming economist with Citigroup, suggested that a bailout by the European Union may be a last-resort option at some point for Greece. But certain German officials have warned against this, asserting that it could set precedents for other EU members such as Ireland, Italy, Spain, and Portugal to expect the same.

Watch a Bloomberg interview with Buiter below. Interested parties can follow daily CDS movements here.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 47.09

2009-12-05T10:12:00.000-08:00

Most indices posted large gains on the week, with previously underperforming groups (Semis, Small Caps, Transports, Utilities, Asia) taking the baton from the previous outperformers (like the Dow). Sector rotation is a signal of market strength and should not be ignored by market bears. Many of the negative divergences we have been tracking for months disappeared this week, showing a lack of ability for bears to capitalize on weakness.

There were, however, a few signals on Friday that may prove to be important for the bearish case. Nonfam payroll data was released, which beat expectations by a large margin. But after a short spike higher on the open, markets sold off for much of the rest of the day. This again proves my oft cited opinion that it is not the news that matters, but rather the reaction to it that we must give heed to.

The US Dollar was the big story on Friday, however. It posted its biggest gain in many months as the Euro and the Japanese Yen especially put in major reversals. It is my belief that the direction of the dollar holds more sway on equity markets than anything equity specific (carry trade), so it is not necessarily "cognitive dissonance in action" to ignore the many positive price movements in equities in favour of the evidence being displayed in the currency markets.

There's a lot to like in the chart above. It has decisively broken its down sloping trendline from March after briefly poking through 3 times in November. The RSI has, as pointed out over the past few weeks, displayed improving readings as the dollar has slowly drifted lower. It now pushes past the 50 barrier convincingly, which has proven to be the high water mark of the latest decline.

The weekly also displays some interesting signals. The MACD has crossed into positive territory along with the histogram. And stochastics are also looking bullish. The decline has been an 81% retrace of the previous advance, which, from an Elliott wave perspective, is not uncommon for a "wave 2" correction. This would imply sharply higher prices in a 3rd wave higher, which would greatly surpass the previous levels. Elliott waves are not always a useful tool, but when their patterns are as compelling as they are right now for the currency markets, extra attention is definitely warranted. Also of importance to the bullish outlook on the dollar is the current extreme sentiment against it, despite the fact that it is above where it was 18 months ago.

In fact, looking at the monthly chart, the extreme bearishness against the dollar looks even more unwarranted. It only sits a few percentage points below where it was in the early 90's. I'm fairly certain that if a survey of laymen were done and asked, "where is the USD relative to 17 years ago," the answers would be far lower, based on the steady barrage of "dollar doom" media coverage. I was recently forwarded an article where an interviewee responded with this intellectual gem:

As far as the "short dollar trade being too crowded," I'd dismiss it as nothing more than Nazi-style propaganda with no basis at all, only an underlying motive of trying to scare people out of their gold and silver positions so that the "bad guys" can take it from them.

I nearly hit the floor in hysterics.

As the near inverse of the dollar index, the euro also posted a large reversal day. The 50 day EMA remains as a barrier to lower prices, holding on all previous declines since the spring.

The Japanese Yen also had a sizable loss on Friday, giving up most of its previous gains of the past few months. Something looks like it went KABOOM here, and it would not surprise me at all to hear of hedge funds caught offside, betting against continuing correlations.

As always, followthrough will be the key to the importance of Friday's reversal. Over the past few months, we have documented dozens of opportunities like this for currencies, commodities and equities to change course. And in an almost comical ineptness, they have failed every time. We will know early this week, whether this is just another head-fake or the early stages of a resumption in trends that began 18 months ago.

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Dubai Podcast and Comments

2009-12-02T09:25:00.000-08:00

Michael Surkan of the Optimistic Bear again invited me on his radio show to discuss the ongoing issue with Dubai and its potential knock-on effects around the world. As I mentioned in my technical update on the weekend, this issue itself is not likely large or relevant enough to cause a global bout of deleveraging. But it may contribute to a loss in the prevailing optimistic tone toward the ability of some sovereigns to make good on their debts. The assumption is that any sovereign in trouble will be bailed out or assisted by another sovereign, the IMF, etc.

But this may be a premature assumption. Explicitly guaranteeing the debts of other sovereigns may increase the perception of systemic instability. German finance minister Peer Steinbrueck learned this last year when he blurted something about not allowing any Euro member to go belly up. He later backed away from that statement, surely after being made aware of the implications: if Germany were to guarantee the debts of all euro nations, they themselves would be perceived as ultra high risk. Abu Dhabi is certainly aware of this potential issue, hence their reluctance to immediately back Dubai.

The next assumption is that many heavily indebted sovereigns will attempt to pay off their debts through traditional measures (tax revenues, inflation, austerity, etc). Many times these measures are not politically possible. So strategic default starts to become a legitimate way out. Once this begins, it is difficult to stop in its tracks. Nobody wants to be stuck paying interest on debts while their competitors operate debt-free. Eventually, this will happen. New political parties will be elected and will view the debt burdens as "obligations of previous regimes."

Right now they continue to play extend and pretend. Extend the duration of obligations and pretend that assets are worth more than they really are. That will work only so long as it appears beneficial for everybody involved (ie. rising stock market). Soon, the sheer mathematics overrun the ability to continue this. As Steve Keen put it so well recently, and as Karl Denninger continually posits, the world's debt burden relative to our productive output is too high and is only poised to rise. And the percentage of our incomes required to service this debt is also too high. This has a corrosive effect on our ability to invest in productive capacity which lessens the other side of the ledger (output). All of the above puts upward pressure on risk premiums (ie. interest rates), which self-perpetuates the worsening servicing ratios.

This is the "Minsky moment" we experienced briefly last year. Confidence was high that it could be prevented. We are now in the process of testing that theory. In my opinion it will fail and another Minsky moment will soon occur - this time with dramatically less confidence in the ability of central bankers to postpone its effects, and less political capital to act as they did before.

Listen to the podcast below (run time about 20 mins).

As always, comments are appreciated.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 46.09

2009-11-29T09:33:00.000-08:00

A holiday shortened week and some wild swings toward the end were not enough to move the major indices very far from the unchanged mark. On a weekly basis they closed flat in North America and Europe, although Asian markets finished considerably lower.

The inability of Dubai World to repay its debts is what gets the blame for the late week selloff. But I am more inclined to believe it was simply jumpy speculators, fearful of losing their gains before the end of the year. Whether or not this event proves to be of any longer term importance largely depends on market participants' willingness to see that Dubai is not alone.

In fact, Dubai is a relatively small shoe among those waiting to be dropped. Excessive debt levels are everywhere. In many cases debt levels and leverage are higher than they were prior to the 2008 credit crisis. The only thing that has changed is sentiment. Popular sentiment is that governments will bailout banks that get in too much trouble; that large companies will be assisted in rolling over their debts; that overleveraged companies will be able to "earn" their way out of their problems in a recovering economy; and that increasing debt servicing burdens do not pose as barriers to any of the above.

As soon as perception is changed, the deleveraging of 2008 will continue anew. None of the problems were actually dealt with expediently. They were merely swept under the rug - given "lifelines." But those lifelines expire. So when the sheer mathematics of the situation meet the expiring lifelines that were given in the panic of 2008 and early 2009, the result will be unsurprising. (Abu Dhabi gave a similar "lifeline" to Dubai last year)

Dubai could serve as a stark reminder of this reality. Or it could be again rolled over and swept under the rug for another year. We've seen warning shots like this before. Remember back to June of 2007, when two Bear Stearns hedge funds blew up. This was quickly made to disappear while stocks continued higher for a few more weeks. Then another big shock in August. And again new highs for stocks into October. Thus, I would avoid taking this recent event as the long awaited "catalyst" for a move lower. I would instead watch for signals of contagion in credit markets. Are CDS spreads blowing out on other sovereigns early this week? Greece, Ireland, Spain, Italy, Mexico, Pakistan, Latvia, Saudi Arabia and numerous eastern European nations should be given extra attention this week.

Unless credit contagion is plainly visible early next week, I would be wary of a short covering rally that takes us to immediate new highs. But if nothing else, this recent incident has given us confirmation to the existence of a massive US Dollar carry trade. On Thursday night, the US Dollar spiked higher as speculators got spooked. Nothing else was spared. Gold was down $60. S&P futures were down more than 40 points. Oil dropped $5. And the phenomenon was worldwide.

Considering this is a technical update, I'll post a few charts before closing out.

First up is a chart of sentiment. It is the Investor's Intelligence bull:bear ratio. As you can see, the percentage of bulls relative to bears has reached a new extreme for the rally. This is typically a contrary indicator. (note: numbers are as of Nov 23rd)

Last week, I pointed out that the BKX (Bank Index) was underperforming and was poised to make a large move. It again underperformed this week. Below is an hourly chart of the past 3 months. Below its November lows, things start to get ugly for this index. Signs of credit stress should show themselves in this index first. Falling share prices in the banks will beget talks of more writedowns (not to mention coming accounting changes at end of year). And more writedowns will beget talks of further government assistance. The mere mention of this will absolutely crush improving social mood. And I don't believe further assistance will be politically possible. The big banks remain insolvent. That is the way they will inevitably end up. Attempts to paper over this reality appear to be unravelling.

I mentioned the Aussie Dollar last week as a carry currency. It weakened further this week. But the New Zealand dollar, while considerably less liquid, is also one to watch for signs of tense carry traders vacating their positions. It got creamed on Friday and is deserving of some attention in the event of followthrough.

Japanese banks are some of the most susceptible to falling asset prices. And they still have not worked through the bad debts racked up in the 80s. The Japanese Nikkei has been falling while the Yen rises to new highs. This is extremely painful to Japanese exporters and there are serious cracks between the new Japanese government and the central bank. Something could crack here too.

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Canadian Real Estate Goes Wacky

2009-11-26T16:56:00.000-08:00

Consider me one of those that never expected the Canadian RE market to rebound after property values began to sink in 2008. But as we have been reminded by numerous bubbles over the years, parabolic blowoffs can last a lot longer than most imagine. Such is the case in Canada's two primary urban markets, Vancouver and Toronto. A concoction of factors has contributed to rapidly rising prices and euphoric expectations about the future.

Of course, when one has messages like the following being printed by newspapers almost daily, it should be no surprise that Canadians have been duped into believing the unbelievable:

“People are re-entering the market – they have the confidence to take advantage of bargain-basement prices. There's been a release of pent-up demand, and that has a long time to play out. Prices have gone as low as they are going to go.”

The above statement came from Gregory Klump, Chief Economist of the Canadian Real Estate Association. Astute readers may equate those statements with those of David Lereah who held the same position with the National Real Estate Association in the US. Lereah later admitted that his analysis was greatly compromised by the position he held - or in not so nice terms, he was a paid shill for the housing industry in the US. Regardless of this unsurprising revelation, the media here in Canada have no problem quoting Gregory Klump as if he were a legitimate expert worth listening to.

But the parallels don't end there for media treatment of the Canadian and American housing bubbles. Time magazine infamously called the top of the real estate market with their magazine cover titled, "Home $weet Home: Why We're Gaga Over Real Estate."

That was June of 2005 - what later was revealed as the top of the national bubble. It continued in some areas thereafter, but the writing was on the wall. In early November, an eerily similar picture arrived on my doorstep in the local Vancouver paper The Georgia Straight.

Intrigued and terrified I proceeded toward page 19, where the feature article lay. Along the way, I was inundated with full page ads for condo developments and just as many for luxury furnishing. The story started out documenting a 24 year old Indo-Canadian pharmacist's experience in buying his first condo. That was fine. But four paragraphs in, journalistic integrity took a back seat to complete fluff. Quoting the pharmacist:

"One of my friends who I used to live with in university, he's like, 'I feel since you bought your place, you've matured. You've completely changed in the way that you are. Before, we used to live the student lifestyle. Now, you're always cleaning your place. You have plants. You look after them. You've even got a cat now. It's like you're an adult.'"

Pass me a bucket. This reminds me of the disgusting marketing tactics used by penis enlargement pill pushers.

But that isn't all. The article goes on, defining the term "puff piece," quoting the most prominent figures in the local real estate market. First up was Cameron McNeill, real estate marketer:

...McNeill, whose company sold more than a billion dollars worth of real estate in the hot housing market of 2007, told the Straight by phone that he thinks the Olympics will keep a spotlight on Vancouver and magnify positive fundamental factors driving demand. According to him, those factors include low interest rates, a shortage of downtown land, good provincial government stewardship of the economy, and a safe investment climate.

McNeill added that it doesn't make sense to compare Vancouver-which has broad international appeal-to other Winter Games host cities. "Who wants to live in Salt Lake City?" he asked. "Lillehammer? I didn't know that town existed until the Olympics happened."

"I think the Olympics creates a euphoria, he stated. "But honestly, I don't think prices are going to spike preceding or post-Olympics significantly. I believe the real benefit of the Olympics is going to come in one, two, three, four years down the road."

Prices rose uncontrollably as soon as the Olympics were announced. It is something that has contributed to Vancouver becoming the most unaffordable city to live in in the Anglosphere with exception of some coastal paradises in northeast Australia (based on price-income ratios). McNeill also speaks of the oft-cited "land shortage." There is no land shortage - not even in downtown Vancouver. Where more square footage is required, we can build skyward, like any other city. There are blocks upon blocks of tired old buildings just waiting to be bulldozed and redeveloped. The map below is downtown Vancouver. Outlined in red is a huge chunk of largely underutilized land. Light industrial warehouses consume most of it. Century old rail yards take up much of the rest. Limited creativity is needed to see how existing land can be converted for other purposes.

Next up was Bob Rennie, another real estate marketer. Naturally, he echoed McNeill's sentiments:

..."It's after the Olympics that we're going to see the impact on real estate." ... "I don't believe that anyone ran back to Turin or Lillehammer or Salt Lake City... to buy a secondary residence or to move the family to safety or to move some money to safety. Vancouver is on the map. We're a world city. We're a brand."

The above statements will come across to most readers as unparalleled in arrogance. In fact, it is common sentiment here in Vancouver. This is best reflected by the Provincial Government's recent change in our provincial slogan from "Beautiful British Columbia" to "British Columbia: The Best Place On Earth." This, along with the above statements from Rennie and McNeill articulate perfectly the peak social mood this city is in. Despite 24 hour rain and eternal darkness for at least 6 months of the year, these folks can't see why anyone would choose to live elsewhere. Completely lost on them is that nearly everybody in the world is somehow passionate about where they are from, just like they are.

Don't get me wrong. Vancouver is a beautiful city. After traveling to over 20 countries in 5 continents, people ask me where my favourite place is. I answer "home." But while the combination of mountains and the ocean is my idea of paradise, I realize it may not be for others. There may be some wealthy visitors coming for the Olympics, but to contend that enough of them are going to want to buy houses to make an appreciable and lasting impact on the market is disingenuous. They will come and spend money. A tiny fraction will actually buy property, something which the market has already priced in.

But the opposite is also liable to occur. A wave of investors that have been holding supply off the market in anticipation of this event could flood the market just before the games, driving prices down and causing panic in those depending on a bonanza. Keep in mind that prices are still down in an 18 month period. This was not in the plans of investors who assumed prices would rise all the way up to the games. Now that this hasn't happened, industry promoters suggest prices will rise after the games.

The article goes on to quote more of these promoters, continually offering only one side of the story. It is never mentioned that even with mortgage rates at all-time lows, most borrowers are spending in excess of 40% of their incomes on minimum mortgage payments. And it is never mentioned that it requires up to 9 times the average household income to purchase a home in many parts of Vancouver (depending on how income is counted). There is only one explanation for statistics like these, many standard deviations from their historical norms. And it is the same explanation almost anytime we see prices divorced from their fundamental values.

Credit Expansion Fuels The Bubble

Like all other bubbles, the major contributing factor to this one is easy credit availability. In order to protect the Canadian manufacturing industry from a rapidly rising currency, the Bank of Canada has recklessly slashed benchmark interest rates to 0.25% and has left them there.

But the real driver of credit expansion can be traced back to the CMHC - the Canadian Mortgage and Housing Corporation. This is a government owned corporation which offers mortgage insurance and buys securitized mortgages in order to keep interest rates low and allow more Canadians to "afford" a home. From the CMHC's website:

CMHC plays a significant role in sustaining a healthy housing market and supporting access to low-cost mortgage financing. Generations of first time homebuyers who have limited down payments have been able to obtain mortgages at rates comparable to those with higher down payments due to our mortgage loan insurance products.

This has been the great enabler. And very much like their cousins Fannie, Freddie and the FHA down south, their very existence serves to accomplish precisely the opposite of what they intend - to make homeownership more affordable. They artificially stimulate demand, pushing up prices in the process. This fuels the notion that prices always rise, causing fearful prospective buyers to make poor economic decisions.

A revealing article was brought to my attention that confirms what we already knew. The CMHC along with the Conservative government were fueling a bubble in order to prevent the housing market from correcting to its natural level. More than $100 Billion in mortgages had already been guaranteed by the federal government, guarantees that would quickly turn into losses should prices fall considerably. Naturally, the solution was to make the problem even bigger. Guarantee even more mortgages, fix prices higher, and hope it all blows over. Murray Dobbin writes:

The facts are that over 90 per cent of existing mortgages in Canada are “securitized” -- that’s the practice of pooling mortgages (or other assets) and then issuing new securities backed by the pool -- MBSs, or Mortgage Backed Securities. That’s what happened with the sub-prime mortgages in the U.S. which (because the whole pool was so diversified) received triple A ratings by the rating agencies. Losses around the world amounted to hundred of billions of dollars.

Credit is still tight in the U.S. because no private investor has the stomach for such risky MBSs. That’s because those losses were private and not back-stopped by any government. In Canada, mortgages have been securitized for years. The Canadian-issued securitizations are called National Housing Act, Mortgage-Backed Securities. Unlike the failed U.S. pools, says Lepoidevin, “In order to find buyers for securitized mortgage pools, the Government of Canada has put guarantees on them” by directing CMHC to guarantee all Canadian mortgages.
...
By the end of 2007 there were $138 billion in NHA securitized pools outstanding and guaranteed by CMHC -- 17.8 per cent of all outstanding mortgages. By June 30, 2009, that figure was $290 billion, a figure Lepoidevin says “…exceeds the total value of mortgages offered by CMHC in its 57 years of existence!” CMHC’s stated goal was to guarantee $340 billion by the end of this year and is on track to reach $500 billion by the end of 2010. Total mortgage credit in Canada will grow by 12-14 per cent of GDP in 2009.

In an effort to prop up the real estate market in 2008 (when affordability nosedived) the Harper government directed the CMHC to approve as many high-risk borrowers as possible and to keep credit flowing. CMHC described these risky loans as “…high ratio homeowner units approved to address less-served markets and/or to serve specific government priorities.” The approval rate for these risky loans went from 33 per cent in 2007 to 42 per cent in 2008. By mid-2007 average equity as a share of home value was down to 6 per cent -- from 48 per cent in 2003. At the peak of the U.S. housing bubble, just before it burst, house prices were five times the average American income; in Canada today that ratio is 7.4:1 almost 50 per cent higher.

This high-risk policy actually prevents the natural playing out of the recession -- that is, the purging of the excesses of the previous boom period. CMHC’s easy-money resulted in a 9.3 per cent increase in Canadian household debt between June 2008 and June 2009.

Even bank economists admit to being concerned about a housing bubble. In a September research note, Scotiabank economists Derek Holt and Karen Cordes said, “…lenders have been scrambling to get enough product to put into the federal government’s Insured Mortgage Purchase Program over the months, and that may have translated into excessively generous financing terms.” Holt suggested that in two or three years -- or whenever the Bank of Canada increases interest rates -- many of these mortgages would be at risk.

The banks themselves have taken on virtually no new risk. According to CMHC numbers in the two years from the beginning of 2007 to January 2009 Canadian banks increased their total mortgage credit outstanding by only 0.01 per cent. Fully 90.5 per cent of all growth in total Canadian mortgage credit outstanding since 2007 has been accounted for by Mortgage Backed Securities. Of course, the banks have no interest in saying no if you have qualified for a securitized CMHC loan -- because they bear no risk if you default.

If that sounds like sub-prime mortgages, it should. Sub prime is any loan below prime. If a bank refuses you a loan, and CMHC gives you one, the loan is sub-prime. As Lepoidevin says in his warning letter, “Every single U.S. lender specializing in sub-prime has gone bankrupt. The largest sub-prime lender in the world is now the Canadian government.”

Hundreds of billions in government backed guarantees are driving prices to unsustainable levels in Canada. Like all other interventions into the market process, this too will fail. Instead of being on the hook for manageable losses, realizing that mistake and doing away with the CMHC, Prime Minister Harper and Finance Minister Flaherty have tripled the size of the problem, making its inevitable failure as systemically dangerous for Canada's financial system.

Unsubstantiated claims by industry hucksters of "pent-up demand" and foreigner buying sprees suggest prices will forever rise into the sunset. Common sense and a little bit of digging indicate otherwise.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 45.09

2009-11-21T18:53:00.000-08:00

The S&P 500 is up a little over 7% since early August. It certainly feels like more. The last 4.5 months have been trying for market bears, sucking out volatility premium and refusing to respond to typical measures of extreme market sentiment. The major indices have again reached a point where they can capitalize on the visibly "weak hands" that are propping up the advance.

Judging from the sentiment on the various "bear blogs" I visit, it seems that most are now unconvinced that a top has been reached. These same venues were all quick to jump on previous declines and tops were called confidently. Now, however, with five distinct selloffs that ultimately failed, bears are more apprehensive. This is typical behaviour and indicative of the market taking the "path of maximum frustration." It seems that it is systematically trying to stretch and squeeze bears as much as possible, making as many as possible insolvent in the process.

But despite the seeming lack of conviction among the bearish camp, progressively more and more evidence is piling up in their favour. Every subsequent leg of this advance has been weaker than the previous and the most recent 3 day decline holds even more potential than was evident in mid-October. See the S&P 500 chart below with the VIX (volatility index) overlaid. It has registered a positive divergence relative to the index. RSI and MACD have each registered progressively weaker readings. And we can also see that volume has steadily declined throughout the course of the decline. These are all classic signals of a bear market rally losing steam.

Also of importance is the non confirmation among secondary indices. The Dow, S&P, Nasdaq, FTSE and Wilshire 5000 have each exceeded their October highs. Every other major index has failed to do so. As I wrote two weeks ago:

Tops are a process, while bottoms are an event. And this topping process appears to be no different. Especially bearish would be for certain indices (like the Dow) to make a marginal new high early next week, while the others fail to confirm. The bearish divergences noted in these pages two weeks ago would become even more pronounced.

This is exactly what has happened. So the appropriate stance would be to become MORE bearish given these developments. But that is not the way sentiment typically works. The emotional "pain" that one experiences being proven repeatedly wrong disables the ability to view market action for what it is. The same was true for bottom callers throughout 2008. By the time they were vindicated, few had the conviction to capitalize.

Below is the banking index. The academic consensus is that banks have recovered immensely since the panic lows of last winter. Naturally, they should be making immense profits with their interest spreads the way they are. But share price action tells a different story. They have been the weakest sector since the early spring rally, and the weakest sector over the past month. Could the market be telling us something different via the underperformance in this key sector? Could the balance sheet issues I have been raising for years continue to weigh on share prices? Or worse, is it possible that as many have alluded to continuously that most if not all of the world's major financial institutions are technically insolvent?

Do note the convergence of the moving averages on the chart below. Typically, when this occurs, a large move in one direction or another is imminent.

The terrible performance of small cap stocks should be worrying for bulls. In a healthy advance, small caps typically outperform larger cap stocks as smaller companies are more leveraged to prospects of future growth. With big cap names like IBM, MCD and JNJ leading the way with small companies lagging way behind, the hesitancy of bulls in this recent rally becomes easily apparent. Big name money managers have been distributing their shares of small companies to retail holders while they accumulate shares of safer names. We've seen this game before, and we know how it ends.

This can also be illustrated by the relatively few stocks that made new 52 week highs in November compared to those that did in October. Plotted on the chart below and smoothed as a 10 day moving average, the weakness be seen clear as day.

On the currency front, we see similar divergences. The Canadian dollar has backtested its rising trendline and turned back down. This is textbook Elliott Wave behaviour, with the break of the trendline being wave 1 and the retest of the underside being a wave two. So long as the trendline is not regained, the bearish case remains intact.

A similar case can be made for other currencies that have benefited the most from the US Dollar Carry Trade. Most notably the Aussie and Kiwi Dollars, the Brazilian Real and to a lesser extent the Euro. They are all in rather precarious positions, and a technical breach of very obvious support levels will most likely illicit further selling and an unwinding of these speculative positions.

But all of these currencies are moving inversely to the US Dollar Index - whether they are part of the index or not. So it is the big kahuna. And when it breaks above, we can be assured that the rest will break below in sympathy. Below is a chart of the US Dollar. Most notable is the trendline dating back to early March. It has been briefly exceeded twice this month (Nov 3rd and last Friday) but failed to close past that mark. Also of note is a parallel trend channel dating back to June. The upper band of this channel correlates roughly with that Nov 3rd high, giving us a fairly good idea of where resistance resides. 76.81 is the number to beat. If we get two consecutive closes above that number, I'd have a high degree of confidence to call the bottom for the dollar. A spectacular advance would be the result.

That's all for now.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Steve Keen Speech

2009-11-20T09:43:00.000-08:00

Steve Keen, the Australian economist, gave a brilliant 30 minute speech last week that can be watched in its entirety below.

We are in agreement that debt levels have likely peaked relative to economic activity and that the likely course forward is an unwinding of this debt back to historical norms. I discussed this at length in my last post, "Missing the Forest for the Trees."

edit: the embedded video led to a repetitiously agonizing 16 second trailer for Michael Moore's "Capitalism: A Love Story." The actual speech can be found at the following link:

Full Speech Here

Although Professor Keen and I would likely agree on more than we would disagree, I have doubts that he would endorse the solutions I proposed in that post. He does not believe, it seems, in the benefits of mutual voluntary exchange, instead electing to cling to the absurd Marxist notion of 'capitalist exploitation' over susceptibly 'irrational' actors. To this extent, he is dead wrong. Keen fails to understand the difference between the neoclassical "rational expectations" thesis (that underpins the EMH) and the more Austrian "rational action." Rational expectations, we would agree, are impossible. To be able to foresee exactly how any action will result, one must operate with perfect information, or in other words, omniscience. This is absurd. No individual or group of individuals can make a claim to this ability - government central planners especially. But rational action is something else completely.

Rational action implies that at the time of decision making the actor will always elect something that he/she believes to be beneficial. Otherwise, no action would be taken. For example, if I were sitting on my couch feeling hungry, I may find the idea of expending energy and money to walk around the corner for a hamburger. Upon my completion of this task, whether I found the result of my action satisfying or not, my thought process was rational. It could have been insufficient and given me a tummy ache. I would then have experienced loss on this transaction. But my action was still rational. Rational action can lead to either profit or loss - two necessary potential outcomes for any action.

It seems that modern economics has been consumed by a utopian desire to eliminate "loss" from the realm of possible outcomes in voluntary exchange. To do this, the central planners seek to minimize our ability to engage in voluntary exchange, making more and more exchange involuntary. The justification for this is that people suffer from irrationality and require decisions to be made for them.

No greater folly has poisoned the minds of humankind.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Missing The Forest For The Trees

2009-11-18T08:59:00.000-08:00

With the 65% rally in stock indices, the idea of actual reform of the financial system seems to have been put aside from serious consideration. Law and policy makers are instead holding out in hopes that 2008 was all just a bad dream, a rogue wave that nobody could have expected, or some sort of other metaphorical platitude designed to distract us from the reality of what happened.

Senator Chris Dodd introduced a bill that supposedly will reign in the financial industry. The bill would have been worth reading, and perhaps even worthy of taking seriously were it not over 1100 pages long. The length of the bill tells me everything I need to know - it is filled with loopholes, concessions, and incentives to ensure that any meaningful change can be interpreted away by the best cunning team of lawyers freshly printed money can buy.

Karl Denninger has a pretty good takedown of the bill. That's not to say it's all bad. But the instances of actual reform (like eliminating regulatory arbitrage) will be outweighed by the damage inflicted by the perception of stability being falsely instilled in the minds of all market participants (ie. everyone). This is the single biggest problem I have with regulation. Lawmakers dance around pronouncing how safe and secure everything is, typically exaggerating such stability to make themselves look better, and people take their word (even if they know otherwise), knowing that it is someone else's ass on the line should all go awry. "Moral Hazard" in other words.

Ron Paul's "Audit the Fed" bill (HR 1207) is also under attack from partisans of the status quo. Mel Watt, a congressman from Bank of America's district, has put forward an amendment to the bill that essentially kills it dead. In politics, apparently you don't have to vote against anything. You simply water down what you don't like to the point of making it meaningless. This way you end up with thousands of pages of laws that cancel each other out, confusing everybody except the aforementioned lawyers who's jobs rely on said confusion. Somehow I don't think this is what was in the minds of those who crafted our systems of government, but I digress.

The point is, despite all sorts of cage rattling, nothing is actually being done. And there is mounting evidence that the opposite is happening: the institutions primarily responsible for the crisis have been given the keys to the city with the hopes that they rescue the system on their own accord. Good luck with that.

But as I implied earlier, doing nothing would be a better outcome than creating the perception of doing something while in fact doing nothing. That way, at least people would remain skeptical of the entire framework and reject its further expansion, thus reducing the potential damage.

But can we really expect anything that will actually have a stabilizing effect to be done given that almost nobody understands what caused the crisis in the first place? Obviously not. If you start with faulty assumptions, your analysis is bound to have faulty conclusions. Right now the assumptions are that:

- Banks were always well capitalized - it was just a lack of confidence that put them in jeopardy - and now that confidence is restored, everything will be fine.
- The lack of confidence caused people to save money - thus dampening consumption from its "normal levels" - and with enough "stimulus" there will be a disincentive to save, spurring consumption and helping boost GDP
- There was not enough regulation - new derivatives and bank activities managed to circumvent existing regulations - and with bigger or newer regulations these activities will be brought under control
- Pay incentives for financial executives encouraged unnecessary risk taking - changing the incentive structures for executives will help eliminate excessive risk
- The lack of a resolution authority was the reason why more big banks did not fail - the creation of such an authority will ensure systemic risk is limited
- The present financial system serves a social purpose by providing access to credit which encourages growth and prosperity

All of these assumptions are false. And there are many others. The decisions being made now are based on these assumptions, and therefore their chance of success remains zero. Just as the avoidance of crisis was in 2007.

What are the real problems?

The problems noted above and their accompanying "solutions" have one thing in common: they disregard debt (credit) as any sort of problem. This should come as no surprise, because those who put forward their interpretation of the issues and those who seek to legislate solutions to them nearly all subscribe to economic ideologies that dismiss credit growth as potentially destabilizing for an economy.

But credit growth is the central problem. And the inability for credit to grow further is what caused the crisis. Again, this was a mathematical certainty to occur at some point. One needs only a calculator and 6th grade math to reach that conclusion. When credit growth is compounded at annual rates between 6-15%, it does not take long for the parabolic advance to reach a breaking point. We reached that breaking point when our debt servicing to income ratio began to rise faster than our incomes and the equity in our primary assets (homes). Credit expansion slowed and asset prices, which had already priced-in years of future credit expansion began to be re-priced to levels more in line with our incomes.

Credit is the central cause of the crisis - the disease (if we are to characteristically resort to medical metaphors). The symptoms of the disease are many, a few of which are listed above. By addressing the symptoms we will not reach a paradigm of increased stability over the current system. It will be inherently unstable. Such has been the case for a century. And something that post-Keynesians like Hyman Minsky and many Austrian economists have been arguing for about as long. The only question revolves around what the "redline" is. What level of debt can be sustained by an economy? Of course, this depends on many factors: interest rates, income growth, productivity, etc. Because it is unknown at what level of debt an economy begins to "choke," we cannot say with 100% certainty that it has been reached. But we can make an educated guess, based on the events of last year, that we crossed that level.

Below is a chart of total public and private debt outstanding in the US. As you can see, total debt is now 4x the size of the entire economy - far more if one factors in unfunded future obligations or if one considers the guarantees issued for suspect financial instruments. (chart courtesy Market Ticker).

Economy bulls believe one of two things:
(1) Debt doesn't matter and this could continue rising for decades, or
(2) We can grow our way out of the problem via productivity advancements and income growth (I'm still yet to find anyone that feels this to be likely).

I have my eyes and ears peeled for any signs of (2), but I just don't see the necessary actions taking place to allow for this (deployment of savings on CapEx by businesses, competitive wages, proper demographic influences, etc). To the contrary. This economic "rebound" is not being led by productive deployments of capital, rather asset price speculation. This is the same reason that led me to believe that the '03-'07 expansion was mostly illegitimate. I was correct then, and I have no reason to believe my analysis was wrong and I just got lucky. The crash in asset values and seizure in credit that I hypothesized would be the result of an illegitimate expansion, happened - only more violently than I thought likely.

As I mentioned above, (1) is false and rooted in fallacious economic theory (Keynesian and Monetarist). While I suppose a temporary expansion of debt levels is possible (so long as interest rates remain low or continue falling, debt servicing ratios don't rise much), my intuition is that the max level was reached in 2008 and there will be neither demand nor supply of credit to allow for further expansion.

The combined factors above lead me to believe that we are on the cusp of another credit seizure and collapse in asset prices for the same reasons it happened last time. Such a collapse is unavoidable. The solution is to let it happen in an orderly fashion, in accordance with the law, and most importantly, with a viable framework for what a replacement financial system will look like once the unwinding is complete.

Discussion on what this system should look like need to begin immediately. If it is not in place prior to the unwinding of the current system, the unwinding runs the risk of being disorderly and vulnerable to being accompanied by the nasty side effects of such a disorderly collapse (ie. starvation, rioting, lawlessness, war, etc).

Simple Proposal For A Sound Financial System

Primarily, it needs to be acknowledged that unbacked credit expansion serves only the needs of a select few (the issuers) at the expense of everyone else. A future system shall make the extension of said unbacked credit a criminal offense. No new laws are required for this. Most western judicial systems have laws against counterfeiting, misappropriation and misrepresentation. As they are written, they need only be applied to the financial system as they are to any other person or industry. Lending anything that one doesn't already possess is a violation of all three laws.

With this one simple interpretive adjustment in the application of our current laws, we can eliminate nearly every adverse symptom of our modern day economies (failure is not an adverse symptom, thus cannot be eliminated). In order to facilitate the above and to structre our financial system in a manner consistent with the law, the following would also prove necessary:

1) Convert all credit obligations for common equity
2) Liquidate the remaining debts that are not backed by existing equity
3) Eliminate legal tender laws
4) Financial institutions will elect to become one of three types of institutions:
i) Depository Institutions - The banks take deposits for safekeeping of a predetermined measure of deposit (dollars, gold, oil, wheat, land, whatever is accepted by the market) and facilitate electronic or physical transactions between like institutions. A fee is charged to depositors for these services.
ii) Lending Intermediaries - These institutions facilitate the matching of lenders and borrowers. A rate of exchange is settled by the two parties at the prevailing market rate. Should the borrower default, the lender experiences loss. The intermediary is responsible for the collection of regular payments and collateral in the event of default. A fee is charged for these services. No risk is ever taken by the intermediary.
iii) Investment Firms - These firms pool capital on behalf of willing investors and use it to speculate or invest on whatever they choose. Returns are based on entrepreneurial intelligence rather than who can take the most risk with borrowed money.
5) Eliminate regulatory redundancies (eg. capital ratios)

There is no social benefit in large, multi-purpose, ultra-leveraged financial institutions. Economies of scale in banking are typically left at municipal lines. Furthermore, our relatively new means of electronic transactions drastically reduces our need for indirect exchange (the use of money). Small transactions can easily be achieved with specie and dollars need only be retained as a unit of account. "Capital" will always be something tangible and the abolition of legal tender laws will encourage the monetization of more types of capital (primarily, the most irregular of commodities).

These changes are not an effort to tame or eliminate the business cycle. Not a "utopia." But it must be acknowledged that much of the business cycle we currently experience is due to the expansion of unbacked credit. Other business cycles will persist based on demographic, social and environmentally driven changes in values (among other factors). These cycles will most often be mild, but sometimes severe. But under the system outlined above, they need never be systemically jeopardizing. Success and failure should be embraced as equal sides of a smoothly functioning economy, neither embraced nor scorned. Yet failure that does occur will be on account of poor entrepreneurial judgement, rather than as result of others' excessive risk taking and systemic collapse.

I challenge the reader to explain coherently how our current financial system serves any greater social function than what I have briefly outlined here. And I furthermore request the reader to address the morality and logic of a financial system so complex as to be incoherent to the average person, while such a simple alternative presents itself.

If anyone has any details to add, I encourage you to do so in the comments section. I was purposely vague on certain areas of my "solution" so as to elicit further discussion.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 44.09

2009-11-15T14:40:00.000-08:00

Major averages again failed to confirm their numerous bearish divergences with increasing selling pressure. The modest declines were not enough to instill a significant amount of fear in traders and dip buyers took advantage of the indecisiveness. Again, we turn to my list of factors that I feel will be sufficient to turn the tides. Some were achieved in the previous decline but not all. We will again have to endure higher prices and monitor continuing divergences prior to incurring more definitive sell signals.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

While it may feel like prices will inevitably rise higher, and perhaps in a final parabolic manner, it should be noted that among the divergences present at both the September and October highs, those same divergences are persisting and even more pronounced at this time. While the Dow has powered higher, only the S&P, NDX and FTSE indices have confirmed that new high in November - and each of those three have only managed it by a few measly points. For a technician that follows the Elliott Wave Principle, this is problematic. A recovery high after an initial decline (ie. a '2 wave'), cannot exceed the beginning of wave 1. This forces the technician to interpret the various indices differently until they confirm. And while there is nothing wrong with doing this, my experience is that when there are so many equally valid interpretations of the price structure it is best to focus on other technical measures until the pattern reveals itself more clearly.

So while there remains possibilities from an Elliott standpoint to continue higher, more conventional technical analysis still argues for lower prices. Significant RSI and MACD divergences as well as pathetically low volume should be warning signs to those of bullish inclination.

One index that does appear to be divergent with the US Dollar Carry Trade is Shanghai. As much as this differs with my overall take on China's dependence on US exports, the technical pattern is very compelling. The Shanghai market appears to have put in an impulse 5 wave pattern into the summer, and a one month correction thereafter. If this holds, the best outlook for the future is that Shanghai has put in two consecutive 1-2, 1-2 legs higher, setting up for a 3rd of a 3rd of a 3rd. In Elliott Wave terms, this is a holy grail setup and argues for MUCH higher prices. A drop below 2900 would invalidate this thesis, creating a somewhat low risk entry on the long side. Sometimes the technical patterns that do not jive with one's fundamental biases are the best trades. Mindful of this, I have taken some long side exposure in FXI as a hedge to my S&P puts.

Good luck this week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

The US Dollar Carry Trade Explained

2009-11-12T10:05:00.000-08:00

The US Dollar Carry Trade has now broken through to mainstream consciousness. This blog, and many others of course, have been talking about this for years. Formerly disparate markets have slowly been converging for the past 10 years. The reason behind this is, quite naturally, unbacked credit expansion.

When there is no or dubious collateral behind a loan, it is only natural that the borrower will seek to speculate recklessly. The consequence of default is not the loss of anything tangible to them, only a poor credit record for a few years. And the rewards are huge if the speculation pans out. As this mentality among borrowers became entrenched, it had the effect of driving all asset classes that were typical recipients of this easy money together. Stocks, bonds, commodities, real estate, art, etc.

The source of this unbacked lending is difficult to pin down. We know that Japan was very active in pursuing credit expansionary policies in order to drive down their currency and support their export market. They lent to foreigners, and foreigners exchanged their Yen for other currencies and bought assets elsewhere. Japanese investors also took to investing abroad and gaining not only on asset appreciation, but on the depreciation in the Yen. This, known as the "Japanese Carry Trade" unwound spectacularly in 07-08. The Yen rose over 40% in 18 months, while the asset markets they were speculating in dropped by at least as much. Most who speculated in this trade likely lost 70% of their capital - all of it if they used any leverage.

Why was Japan the obvious choice for this? Because their interest rates were at near zero for years and there was no indication that they would be raised any time soon. Sound familiar?

It should, because that is the exact perception in the US. And that perception is probably correct. Benchmark rates will not be going anywhere soon. And now that the Fed has involved itself in many other markets (agency paper, money market funds, commercial paper, etc) there will be many moves to unwind these programs prior to raising interest rates. So there is no risk to this trade, right? We know better. So does everyone else. Everyone thinks, however, like the Japanese housewives playing in the forex markets, that they will be able to get out first once it begins to unwind. Simple mathematics tells us it is impossible. Like how 90% of drivers rate themselves as "above average."

In the minds of most, this doesn't matter. All that is important to today's ultra-short term minded investor is "how long will it last" and "how much money can I make?"

Often, once a trend has become common public knowledge, it is already over. This is the logic behind the magazine cover contrary indicator. Sometimes, however, the trend needs to become manic prior to exhaustion. In my opinion, we have already reached this point. Most others see the potential for it to last longer and run deeper. I suppose they could be right. Thinking back to early 2007, it looked fairly apparent that the Shanghai market was going to put in a top and was getting ahead of itself. It went on to double itself from those levels. It then lost 73% - halving those initial 2007 levels. Bubble callers were vindicated in the end but likely lost in three ways: shorting too early, missing a huge run-up, and being too shy at the real top.

There is a fine line between early and wrong. It is the same line between profit and loss. The flipside is that markets have an uncanny way of convincing you you're early, right before they turn around. I call this the path of maximum frustration.

The US Dollar Carry Trade is a bubble - just like all the others. It will unravel. I'm doing my best to hedge in the case of being too early in order to ensure I can participate in the unraveling process, which promises to be a doozy.

I look forward to the day when investing is again more about increasing productivity, wealth, prosperity, and less a game of Jenga. But when life gives you oranges...

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 43.09

2009-11-08T10:39:00.000-08:00

The S&P 500 posted gains on all 5 days this week to retrace nearly 61.8% of the prior decline. The advance was achieved on extremely low volume, and with decreasing participation. The Russell 2000 managed to retrace only 43% of its decline, while the larger cap Dow 30 made up 83% of its previous fall. The generals are charging up the hill while the troops lag behind, paralyzed with fear.

Tops are a process, while bottoms are an event. And this topping process appears to be no different. Especially bearish would be for certain indices (like the Dow) to make a marginal new high early next week, while the others fail to confirm. The bearish divergences noted in these pages two weeks ago would become even more pronounced. But that is not necessary. The oversold conditions have been worked off by both time and price and should not be hindered from continuing their descent from fantasy land. New highs in all the indices would indeed be frustrating (recall August to October 2007). But the technicals all point in the same direction, and evidence mounts almost daily that market action is conducive to lower prices, not higher.

Below are hourly charts of the Dow Industrials and Russell 2000 respectively. Notice the extreme divergence.

As mentioned earlier, the internals of the week's advance were extremely weak. Below is the up/down volume ratio. The blue line is a 10 day moving average of the ratio. Lower readings above zero indicate weaker participation on rallies.

The commodity complex has been weakening despite Gold's continued strength where a non-confirmation in silver may prove difficult to surmount. Below see the CRB index and Silver.

That's all for now.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Crisis in Colombia Brings Opportunity

2009-11-05T16:07:00.000-08:00

I often talk about generational cycles having major impacts over long-term trajectories in markets, and societies in general. To most, it sounds like a very fatalistic way of looking at things: no matter how hard we try, we're destined to repeat our failures. This was proven true again in 2008 as markets tumbled after debt levels rose uncontrollably for decades, securities fraud was rampant and corrupt politicians and regulators did their best to cover up these problems - and in many cases perpetuated them themselves. It was like a carbon copy of what led to the Great Depression.

But generational cycles are not always bad. Like all cycles of their sort, they have expansionary and contractionary periods - very much like the seasons. So while all signs point to much of the western world (more accurately, any nation that participated in WWII) being in the thick of a generational crisis era, there are other parts of the world, that are in different points in their own respective cycles. This may prove to be important for investors, looking for growth around the world as their own asset markets experience much needed corrections.

Many South American nations fit this description. Specifically, Argentina, Brazil, Chile, Colombia, Peru and Uruguay.

Whenever I am in conversation with other investment managers and economists, bringing up these countries as ideal areas for investment results in scrunched noses and shaking heads. After all, they have recent histories of hyperinflation, corruption, drug lords and brutal dictatorships.

"Precisely," I answer.

The recent histories of these nations are awful. Just 20 years ago, nearly all were controlled by corrupt dictators. Senseless killing was a way of life. Political opponents would simply disappear or fight guerilla wars with government armies. Socialist price fixing schemes left food and medical care in short supply.

In 1985, the military dictatorship was overthrown in Brazil. In 1988, democracy was restored in Chile. Pablo Escobar was killed in 1993 and the drug cartels that terrorized Colombia were nearly completely destroyed a few short years after. Argentina's "Dirty War" ended in the early 80's and democracy was restored. Unfortunately, continually poor economic policy has led to recurrent crises. Regardless, the standard of living has continually risen since 1990.

The recent memory of these issues provides the perception that South American countries were always this way and always will be. But this is not the case. Argentina and Chile in the early part of the 20th century were some of the wealthiest and most advanced nations in the world. European wars led to an influx of educated immigrants that embraced the resource rich lands and prosperity abounded. "He's as rich as an Argentine" was a popular expression.

After spending 5 months during '06-'07, primarily in Chile, I feel like I can offer some insight into how they have definitely changed their ways. The Chilean people are incredibly well educated. And they are consistently ranked as having the most economic freedom of any country in the developing world. One particular observation stuck: the Chilean's commitment to higher education. Riding on the subway in Santiago was the best way to experience this. In much of North America, the banner ads in the station and train cars are full of chewing gum, television shows, deoderant and other useless gimmicks. In Santiago, most are occupied by post-secondary schools. And if one were to ride the subway in the evening, many of the commuters are not going home from work, they're on their way to night classes. Chileans are intently focused on the future. And when one talks about the future there, one talks about 10 years, not 10 months.

The reason behind this can easily be found in demographics. In conjunction with the end of major crises and the beginning of new freedoms, people tend to be fairly jubilant, resulting in baby booms. And in the late 80's/early 90's most of these nations I've mentioned experienced enormous baby booms. Today, they have some of the youngest populations in the developing world with - according to the CIA world factbook - between 23-29% of their populations 14 years old and younger. China, in contrast, has only 19% (and enormous issues with male/female disparity). Germany and Japan sit around 13.5%. Other nations with higher ratios of young populations are typically marred by high infant mortality rates, famine and/or HIV.

With such a burgeoning young population and the recent memory of brutal dictatorships still ingrained in the memories of their parents, these societies are naturally disinclined to extremism, protectionism, violence and corruption. The best analogy for this is America in the decades following WWII. The generational High and generational Awakening eras are typically favourable eras for investment due to the natural increasing demand from younger generations. They are also characterized by something else: utter paranoia of the bad times returning. Again, think of America in the 50's and early 60's. Nuclear war with the Soviets was thought of as an inevitability. And every recession was met with fears of a depressionary repeat of the 30's. Each bout of this pessimism was met with large stock market declines, only to be followed with breathtaking rallies, innovation booms and a rising standards of living.

With that in mind, I came across an article yesterday about Colombia that typifies this mentality. The content of the article is not all that important (the Colombians are having continuous issues with neighbouring Venezuela and their lunatic dictator Hugo Chavez). But the fact that so many are fearful of this escalating into a broader conflict is typical of a generational Awakening era. These are the types of events that dampen positive social mood, creating huge selloffs in asset markets and allowing for low-risk entries into burgeoning markets.

South American stock markets have indeed come under the same allure as other emerging markets from the US Dollar carry trade. And they will likely succumb to similar panics when this inevitably unwinds. But the favourable demographic positions of many of these nations will have me buying dips in anticipation of continued future prosperity, stability and an eventual leadership role in world affairs.

South America is often lumped in with other emerging markets as part of the same US consumer dependent globalization trade. I have reason to believe their growth is based on firmer foundations.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 42.09

2009-11-01T05:00:00.000-08:00

Today will be a more in-depth post covering the equity and currency markets.

The largest one week decline since early May and the breaking of numerous important trendlines has shifted the odds in favour of the bearish camp. While near term technicals provide good cause for an early week bounce, last week's change in character suggest that this should be used to lighten long positions as opposed to the previous norm of buying dips. The list of indicators I have been using to confirm this move is not yet complete, however. There remains a few holdouts. Presumably, a significant push below the early October lows (1019) or the September lows (991) would satisfy these requirements.

First, the list of indicators I have been tracking, posted as it has been for the past few weeks:

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

Below is a weekly chart of the S&P 500. It has breached its trendline from the March lows significantly. However, it is common practice for price to test the underside of that line once broken. Notice the negative divergences on the RSI. Also note the imminent MACD crossover.

Weakness in the secondary indices is one of the signals I have been watching for at a market top. We had a failure in many of these indices to surpass their September highs, even as broader indices did so. And now we have these same indices underperforming on the way down. This is textbook relative weakness. And it is exactly what one would expect to see at a top. In addition, we have RSI divergences, MACD crossovers, trendline breaks, increasing volume and important moving averages being broken over the past week. I don't know how much more clear-cut this could be. In order of appearance below we have Dow Transports, Dow Utilities, Russell 2000 and the Semiconductors Index.

Please do not read into this that a crash is imminent. As we have seen countless times, such divergences can persist for longer than most expect. Throughout the 2007 topping process, we had such persistent divergences in many indices even as the broader indices continued higher. Each push higher resulted in even stronger divergences while slowly convincing people that they were not important. As soon as attention dissipated, only then did they manifest into significant declines.

As for market internals, we had been experiencing progressively weaker market breadth and advancing volume as the indices marched higher from their July lows. As expected, many of these indicators are now displaying their weakest readings since the March lows. Below see the put/call ratio, advancing/declining issues, advancing/declining volume and daily closing TICK (the lone holdout).

The confirmations I have been expecting in the currency markets have been mixed. The USD strengthened by over a percent this week and trendlines were only moderately violated. Continued weakness in the Canadian Dollar and the Euro are the keys to confirming a bottom in the USD. Support for these currencies is wearing thin, however, and failing a swift turnaround, the stage will be set for an unwinding of the "US Dollar carry trade" that would eventually send it significantly past its March high.

The Canadian Dollar specifically appears to be at a very important crossroads. It has experienced some of the most speculative flows during the so-called 'recovery.' As this hot money unwinds in the stock and commodity markets, the Loonie could get hammered significantly. I am using the Loonie as a barometer for risk appetites and watching closely.

The Euro, as I have repeatedly mentioned before, does not have any better intrinsic value than the US Dollar. Yet for some reason Dollar bears have latched on to the currency as some sort of safety hedge. In my opinion, this is quite ignorant to the enormous problems present in the European banking system, their exposure to risky loans in Eastern Europe, and the political issues between the more stable Northern European government balance sheets and those in Ireland as well as the PIGS (Portugal, Italy, Greece, Spain) all of whom are running massive deficits in violation of the Maastricht Treaty.

Technically, it has only marginally broken its trendline, a situation that upon reversal could become a "pinocchio" buy signal. Again, increased attention is warranted.

Good luck next week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Podcast #2 With The Optimistic Bear

2009-10-31T10:55:00.000-07:00

I had another interesting discussion with Michael Surkan of The Optimistic Bear on Friday. Among issues touched upon were the last week's stock market performance in the face of primarily positive economic numbers; foreign currency issues and their effects on globalization; emerging markets and whether their outperformance is genuine; the positive nature of various malinvestment liquidations; nanotechnology; the effectiveness of fiscal and monetary stimulus and quite a bit more. Interested readers may wish to have a listen:

Thanks again to Michael for having me on the show.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Deflationary Forces Still Hard At Work

2009-10-28T07:59:00.000-07:00

Today will be a quick post on some of the more deflationary forces that have been going on under the surface over the past few months. It has been fashionable of late to speak of how central bank monetary stimulus and government fiscal stimulus has "brought us out of recession." Tomorrow morning we will get US Q3 GDP numbers, and they will surely be positive. The media will sing the "recession is over" tune until they are hoarse. But they will be wrong. As per usual.

To be sure, many companies and individuals have used the relatively favourable conditions in the bond markets to build capital, refinance their debts and a select few are even acquiring new assets and R&D funding. But this is the exception, not the rule.

What is easily seen by casual observers is that governments and central banks went on a shock & awe campaign in a "war against recession." News happened to stop getting progressively worse around the same time, and the layman assumes one caused the other. They conveniently forget that both fiscal and monetary easing started more than a year and a half prior to the March lows in the stock market. So did these policies all of a sudden go from failure to success overnight? Or had the stock market simply gone "too far, too fast" and needed time to sort out the good from bad?

It is my contention, that it has been a mere correction in the mood of investors and not in the actual health of the capital markets. I have discussed my opposition at length to the money multiplier model of monetary expansion used by central bankers. I believe that their models are incorrect. They state that if they (the central bank) is to deposit $1 of newly created 'money' at a member bank (Bank of America, for example), then BofA will then go and lend $10 to others. As has been discovered by numerous economists over the course of the past few decades, this is precisely backward. Banks lend out money first, based on their belief in the ability to make a profit on their loan. Thereafter, they acquire deposits to meet capital requirements. This explodes the myth that any of the Fed's asset swaps or QE has somehow inflated the money supply. They have merely shifted the existing supply around, hoping that in its new home it will multiply. It hasn't. And it won't. Because it can't.

Below is a chart of the past 60 years of commercial and industrial lending measured as a percentage change from the prior year and as a percentage of total GDP. Despite the hockey stick graph that so many like to point to as evidence of impending hyperinflation, the banks that have been given this so-called "printed money" are not lending it. Lending is falling off a cliff to businesses and shows no signs of turning around. (Chart courtesy Econompic Data)

Why aren't they lending? Are they just being greedy and keeping the money for themselves as the many populist cries imply? Or is something preventing them from lending? Glad you asked. For those with a short memory, the panic of 2008 was caused by people defaulting on mortgages. With a 50% rise in the stock market, one would assume that problem has at least dissipated slightly, right? Wrong. Mortgage delinquencies continue rising. See Exhibit A (from Calculated Risk):

That doesn't look like much in the way of improvement to me. Fannie is in the same bind. And the FHA, which has been recruited by the government to pick up the slack in doling out garbage mortgages, is even worse. Below we can see that although home prices may have ticked up in response to HAMP (cash for cabins), foreclosures (blue bars) have not yet caught up to delinquencies (red bars).

What does that mean? It means that banks cannot foreclose on properties fast enough. Alternatively, they may feel that they can modify these loans or that those that are delinquent will get their jobs back in due time. That is wishful thinking. Not even the flaming optimists see employment turning around anytime soon, and banks have already found that more than 60% of loan modifications re-default within mere months. Either way, there is massive supply of homes that are soon to be bank owned and liquidated.

So I suppose that would explain why banks can't do anything with their "excess reserves." Also keep in mind that much of these reserves are on temporary loan from the Fed in exchange for other garbage securities.

But it is not just the banks that aren't lending. Trade Credit is falling sharply also. As defined by Wikipedia:

Trade credit exists when one firm provides goods or services to a customer with an agreement to bill them later, or receive a shipment or service from a supplier under an agreement to pay them later. It can be viewed as an essential element of capitalization in an operating business because it can reduce the required capital investment to operate the business if it is managed properly. Trade credit is the largest use of capital for a majority of business to business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses

Chris Whalen of the IRA Analyst interviewed two of the leading corporate credit ratings firms, Jerry Flum and Bill Danner. Below are some excerpts, but the whole interview is worthy of a read.

The IRA: So what are you seeing at CRMZ in terms of corporate credit, accounts receivable and the data you gather?

Danner: The dollar value of accounts receivable we collect are down sharply. In general vendor credit is down much more than the drop in bank lending.

Flum: Not only that, but you've got to remember that the rate of gain and the expansion of bank lending is down. If trade payables are also down, then there is no grease for the real economy.

Danner: Yes, to put a finer point on it, trade credit is down bigger than bank lending. Remember that commercial receivables are huge, something like 3x commercial bank loans. This is the real economy's lifeblood, but trade credit is down more than the decline in sales and down more than the decline in bank lending, including metrics you guys track on banks like exposure at default ("EAD").
...
Flum: I have been doing this for 40 years. Started in the financial business after working at a law firm. I got my head handed to me in 1973-74 in my hedge fund and had to learn how markets behave. When I boil what I've learned all down to one factor that drives the markets and an economy, it is debt. Debt vs. GDP, for example. Every dollar of debt moves a future purchase into the present.

The IRA: In a fiat money system, there is no money, only credit.

Flum: Correct, and as credit grows we spend more of it now. So, if you look at debt vs. GDP, we are already at record levels. We can also look at incremental debt vs. incremental GDP. In the 1950s, it took $1.50 in debt to produce an incremental $1 of GDP. Today it takes more than $6 in debt to produce a $1 of GDP, so we are approaching the end of the game. This economic inefficiency is a sign of being closer to the top than the bottom and a new beginning.
...
The IRA: So the efforts to restore the commercial paper markets and add liquidity to the markets has not trickled-down? The Fed would tell you that they have restored normalcy

Danner: The numbers we are seeing on A/R and trade credit volumes are continuing to get worse, not better. A big part of that is financing.

So much for monetary stimulus. Behind the smoke and mirrors from the central banks and the flashy lights in our financial media, absolutely nothing has been achieved by these measures. That is, if one chooses to ignore the unintended consequences.

But what about the government stimulus measures. Surely the various programs and stimulus cash is having its effect on the economy? Not likely. Again, the models that suggest that this works suffer from a similar affliction: they ignore debt. And in a credit inspired recession, adding more debt does nothing good. Sure, it can be good for some people who are direct recipients of the loot. But for the rest of the taxpayers and businesses, the implied future rate of taxation rises in lockstep. This is something that I have mentioned before, but I had not heard anyone else take up the cause. Until yesterday when I happened upon a fairly wonkish post from Rob Parenteau. In it he makes the same observation:

DoctoRx next considers a contradiction in using policy responses to debt deflation dynamics that require higher government debt. He suggests we best think of the government balance sheet as consolidated with the domestic private sector balance sheet, since Treasury debt is an obligation that ultimately must be paid by taxpayers. This of course is a variant of the Ricardian equivalence argument, whereby fiscal stimulus is deemed to be ineffective at inducing economic growth since the households receiving higher income from deficit spending simply save the entire proceeds in expectation of future tax liabilities of equal magnitude. DoctoRx is probing along similar lines when he observes, “after all, the private sector has to debit its bank account to send the funds to the government in order to buy the debt. All that is really happening is that the private sector had cash, and now the government has the cash with some repayment terms.” Fiscal deficits are, in other words, just an asset swap.
...
Money and finance are not neutral with respect to real economic outcomes, nor is money simply a veil for real exchange, as is taught in mainstream economics and as is held as holy truth by contemporary central bankers. Read a little Fisher or a little Minsky, and then reflect on recent events. Did we destroy some productive resources, lose some technical knowledge, or otherwise experience an exogenous productivity shock to drop into the deepest recession of the post WWII period, or was the drop in real economic activity in no small part a result of a highly leveraged private financial and nonfinancial sector encountering some very drastic financial conditions as fraudulent loans and fraudulent debt ratings were exposed? Does the government need the private sector’s money to “fund” its expenditures when a) the nonbank private sector cannot create money, and b) the government creates the money the private sector accumulates to pay taxes and buy bonds? Under what conditions can the business sector as a whole accumulate tangible capital without issuing financial liabilities, and are those conditions we observe in the real world around us?

Again, read the entire piece. Have a drink beforehand as it runs deep to the present situation. Parenteau, the Austrians, and followers of Minsky's Financial Instability Hypothesis understand that debt is the problem. They understand that either shuffling it around (as are central banks) or creating more of it (as are governments) is not a viable way to combat credit deflation, while it may 'work' during a run-of-the-mill overcapacity recession.

The equity and commodity markets are acting as if there is no difference between the characteristics of the two separate types of economic contractions, responding as they would to the expected recovery from undercapacity. As we can see from the charts above, the deflationary forces that began the crisis two years ago continue to accelerate.

Bernanke and Geithner are trying to fit a square peg in a round hole. Vegas odds are 1:1 on them succeeding.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 41.09

2009-10-25T09:17:00.000-07:00

Another interim top has materialized. Like all of the other tops along the way, it will require a significant change in market character prior to allowing for confirmation of the primary top I am expecting. For the past few weeks I have outlined a number of factors that would help make this distinction.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

We are seeing early signs of divergence in certain indices, but not others. And market internals seem to be getting progressively weaker on any push higher. On an anecdotal level, I can sense mood shifting toward pessimism again. Earnings reports, while still very weak, have largely blown away analyst 'expectations.' Yet for the most part, this has not resulted in favourable reactions in the overall market. The US Dollar remains subdued, falling marginally with the market this week.

On March 3rd, I wrote about certain stocks and sectors that had been displaying relative strength in opposition with their November lows. Indeed, most of the stocks mentioned have enjoyed more than 100% gains from their lows. Of course, one would have done better buying some of the worst performing sectors, but picking the winners that experienced 1400% gains over those that only got 14% was impossible to determine at the time. Back in March, there was little that would suggest Fifth Third (FITB) would drastically outperform Keycorp (KEY), but momentum chasing of the former allowed this to happen.

I am currently tracking a list of stocks and sectors that are showing relative weakness to the overall market. Similarly, there may be greater downside potential found in those that have made the greatest gains over the past 7 months, but with those comes also greater risk. Trading in high beta sectors is a double edged sword. Below are some sectors that have failed to confirm the market's new October high. If I were looking for short opportunities, these sectors are where I believe the lowest risk will be found.

Transports and particularly the railroads have shown some of the most notable underperformance. For the week, both finished down more than 5%.

The solar energy sector topped in June and has been meandering sideways since then.

The biotechnology sector happens to be one of my favourites from a long term fundamental standpoint. But it is now also an underperformer over the past month, giving back more than 6% last week alone.

It is no secret that the problems with the banks are yet to be resolved. For much of the rally, bank share prices have been the leader in hopes that eventually "everything will work itself out." But they are not leaders any longer, showing weakness over the past two months and only able to marginally achieve new highs despite better than expected earnings numbers.

But weakness can be seen even more in Canadian financial institutions.

Another area that has received heightened attention by central planners is the housing market. It is believed by most contemporary economists that if home prices would just start rising again, then all the problems will go away. This comes from a fallacious interpretation of what went wrong last year, but it hasn't stopped them from trying all sorts of policies to fix home prices. Regardless, the homebuilding industry is now also displaying weakness. "You can't fool all the people all the time..."

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Podcast With The Optimistic Bear

2009-10-21T08:43:00.001-07:00

Last night I participated in a podcast with Michael Surkan of The Optimistic Bear.

We discussed a number of issues ranging from international banking, the inflation/deflation debate and health care to generational cycles and the secular changes I see developing in attitudes toward risk. You may listen to the full interview in the player below.

There were some other issues that I was hoping to touch on. For instance, I did come across as quite the pessimist in the interview. In fact, I see myself as more of an optimist. I view the contraction of credit and falling asset prices as positive, not negative. In order for organic productivity-inspired growth to occur, the dead waste needs to be cleared first. So I don't view the onset of depression as "armageddon," rather as the first stage to future prosperity.

If time were never an issue, I could have also elucidated some areas I believe will be kind to investors in the intermediate term. I am very positive on the prospects of South America. Much of the continent has far more favourable demographics than other emerging markets. And from a generational perspective, many nations have put their dark histories with dictatorial governments behind them (eg. Pinochet). Chile, Colombia, Uruguay, Brazil, Peru and eventually Argentina (when they get their house in order) should all be ideal investment areas over the coming decades. I am also very positive on the eventual application of nanotechnologies, and I believe this will be a spectacular area of growth once the required investment resources are freed from their current wastefulness.

I'd like to thank Mike for being a great host and having me on his show. Hopefully my readers find it to be worthy of their time. It was the first time I have attempted something like this, so any feedback on the subject matter or even my communication abilities would be much appreciated!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 40.09

2009-10-18T14:29:00.000-07:00

The major indices finished the week higher, a feat achieved 24 of the last 34 weeks (70.5%). Rising stock prices seem to be ingraining themselves into the collective conscience of market participants even as confidence measures remain somewhat benign. It tells me that while many do not believe the economic recovery story, they have become exhausted with trying to short it. Many have taken a similar posture as myself, waiting for confirmation of a move before committing capital to shorts or liquidating longs. Being a person constantly looking for contrary indicators, my own emotions and those of others typically provide clues to changes ahead. Perhaps this is one of those times...

It is a market driven by momentum. In talking with various colleagues, I try to get a handle of how much conviction buyers seem to have. I don't get the feeling that many of those holding substantial long positions would tolerate much of a decline before checking out. Where are the stops? A 10% market decline? If many are indeed acting under this sort of a mentality, a selling panic could easily ensue once this line is crossed.

But that is subject for another day. Today, we have a climbing market to chart. Other than a nasty underperformance this week in banks, transports and the nasdaq, we have not yet come close to satisfying the qualifications I am waiting for.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

The recent push from the early October low of 1019 has certainly been achieved with declining participation. See the divergence below:

The ratio of the Dow to the S&P seems to move contra-cyclically. The Dow underperformed on the way down and now outperforms. A divergence in ratios like this, as well as with the Nasdaq may provide a window to the market's internal happenings.

I'm also watching the ratio between the VIX and VXV. This monitors the premium/discount of 3 month volatility to that of the present. As future volatility gets sucked out of future option prices, the ratio falls. For months, option traders were willing to pay a premium for September or October options. Due to seasonality it seems that many had been forecasting a market turn by either of these months. With October expiry out of the way, any distortions this may have created may be free to resolve themselves.

I do find it interesting that such an enormous consensus exists in utter hatred for the USD. Nearly everyone has been sold the story that the Dollar is destined to soon become worthless. But what is really interesting is that this has occurred while the dollar index remains well above its prior lows. I am anticipating a sharp move higher one of these weeks that will trigger quite a bout of short covering.

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Breakout, Bonds, Oil and Earnings

2009-10-15T09:20:00.000-07:00

Third quarter earnings have been seeping out this week, mostly to critical acclaim. Thus far, profits from the big financials appear to be mostly concentrated in proprietary trading (again). And once again, there's very little transparency to the banks' actual balance sheet due to the suspension of mark to market accounting. The plan is that these rules will be reinstated by yearend, and the consequences to earnings are quite obviously ground-moving. Cynically, it should be assumed that these banks will throw untold millions at lawmakers to have the rules postponed again. But the real question is not necessarily the rules themselves, rather the willingness of speculators to take the risk.

Risk appetite trumps fundamentals.

I wish I could be bullish on the economy. But I do not see the proper characteristics for sustainable economic growth. Money is being piled into the old bubble sectors (FIRE - Financials, Insurance, Real Estate), which themselves produce no wealth. Meanwhile, small businesses, startups and individual consumers are starved for both capital and access to credit. I struggle with how this could go on for so long, but I then think back to '07 when everything was similarly levitating in the face of the blatantly obvious. The necessary deleveraging was also avoided in '01-02 and continued for years. So while I prepare for the possibility that this lasts much longer than anyone expects, I don't foresee it doing so.

One thing I do expect is confusion. Lots of it. I expect to see some major separation from previous positive correlations. For instance, long term interest rates have risen substantially over the last two weeks (30 yr treasury yield up 43 basis points), and I have a feeling that this may be a more permanent sort of move. I would not be surprised if the long bond starts trading as a risk asset on any subsequent market decline. Rising rates are also something that has the potential to kill what many are calling a bottom in the housing market (I think not).

Oil may also be something that finds some separation from its recent 'beta' with the stock market. It seems like forever, but there was a time when rising oil prices were seen as a bad thing, and every tick higher in crude was matched by a tick lower in stocks. Oil broke out above new highs this morning above my long standing cited resistance around $75, many technicians see it with little resistance up toward $100. Whether the market reacts to this negatively or not, it is going to start putting big pressure on consumers. And if there is one thing that angers populations more than anything, it is rising gas prices. It would be sweet irony if rising oil prices, at first thought to be a harbinger of economic growth, eventually killed the rebound in social mood and sapped the willingness of consumers to consume - just as we edge into Christmas shopping season.

Traders and investors become married to correlations. When they break, they cause chaos for weeks at a time while managers reposition their portfolios for what seems like the "new normal." The present correlations have held for quite a while, likely lulling many into complacency. Watch them carefully.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 39.09

2009-10-10T09:44:00.000-07:00

The material change in market character we were looking for did not materialize. As suggested, the first whiff of this led to bulls piling back on and quickly retesting the previous highs. Without significant followthrough from last week's decline it was readily apparent by Monday that dip buyers had not exhausted themselves and the risk seeking behaviour we have witnessed over the last seven months would reassert itself.

The Elliott Wave structure was confirmation of this after failing to register 5 full waves to the downside. The most probable counts now show the S&P rising in either a 5th wave to ~1120 peak or a 1st wave of something far more bullish (projecting to over 1200). The rally obviously intends to destroy as many bears as possible prior to reversing. Maximum ruin indeed.

Two weeks ago I outlined 3 indicators I was watching for confirmation of a rally peak. I will expand on that this week with a few more and will continually track them as the weeks pass. Readers can feel free to add their own.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.

All or most of these factors should be present in the first 10% decline from the highs. Until then, it should be considered that the bull trend remains intact. It seems that too many are focused on calling the exact top (I'm guilty of this sometimes) rather than waiting for confirmation. Keeping it simple is typically the most prudent course when using technical analysis for timing entries and exits. And most of the best known traders adhere to this principle. Giving the market 10% on either side of a large move still allows one to participate for 80% of the move.

The German DAX has a very logical target denoted by the blue line on the following chart. The 6100-6200 area has proven to be a point of inflection numerous times over the past few years. And it is also where the Mar-Jun wave A would be of equal size to a wave C peak.

Finally, it needs to be pointed out that the US long bond experienced two consecutive days of intense selling to close out the week. What is it trying to say? Is it sensing a potential rise in the Fed Funds rate? Is the long bond now trading as a risk asset class? Is the cessation of Fed POMO activity being reflected by interest rates rising to a more natural level? Nobody knows for sure, but the activity is certainly deserving of attention.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Weighing In On Fractional Reserve Lending

2009-10-06T11:32:00.000-07:00

Mish and Karl Denninger have been having an interesting back and forth on the topic of fractional reserve lending. There is vast disagreement on this subject even within various schools of economic thought. It does not seem to be an ideological debate, but rather a juridical one, which makes it less emotional and perhaps worthy of debate.

Both Mish and Karl bring up good points about what is fraudulent about our financial system. Mish feels it is more systemic and Karl thinks it is a lack of regulatory will (due to capture, corruption, etc). I have stated previously that with a proper legal foundation, no regulation is necessary. So I would have to agree more with Mish. I sent him an e-mail this morning, which I will republish here:

Mish,

The best arguments against FRL I have read can be found in Jesus Huerta de Soto's Money, Bank Credit and Economic Cycles.

You touched upon this, but de Soto has a better way of explaining it through a historical (dating back thousands of years) understanding on the nature of contract law. When a depositor gives their money to a bank, they are doing so under the impression that the bank keeps their money safe. If this were not the case, people would buy bonds or some other investment. Historically, the act of keeping money safe was a service that depositors would pay for. By lending money out that has been promised to someone else, the bank is abrogating their contract with the depositor. In order to do so, the bank must consider the deposit as an asset, something the depositor simultaneously believes he has. Very simple contract law states that two separate entities can not claim ownership to the same asset. Thus, the bank is guilty of misappropriation by promising safekeeping of something they do not possess.

The confusion seems to surround the difference between two distinct types of contracts: the Monetary Irregular Deposit and the Monetary Loan. Below is a table copied from pp. 19 of Money, Bank Credit and Economic Cycles, contrasting the two types of contracts:

Economic Differences:

Monetary Irregular Deposit: 1. Present Goods are not exchanged for future goods. 2. There is complete, continuous availability in favour of the depositor. 3. There is no interest, since present goods are not exchanged for future goods.

Monetary Loan: 1. Present goods are exchanged for future goods. 2. Full availability is transferred from lender to borrower. 3. There is interest, since present foods are exchanged for future goods.

Legal Differences:

Monetary Irregular Deposit: 1. The essential element (and the depositor's main motivation) is the custody or safekeeping of the tantundum [deposit]. 2. There is no term for returning the money, but rather the contract is "on demand." 3. The depositary's obligation is to keep the tantundum available to the depositor at all times (100 percent cash reserve).

Monetary Loan: 1. The essential element is the transfer of availability of the present goods to the borrower. 2. The contract requires the establishment of a term for the return of the loan and calculation and payment of interest. 3. The borrower's obligation is to return the tantundem at the end of the term and to pay the agreed-upon interest.

Similar to a monetary irregular deposit would be the storage of crude oil in large tanks. The depositor of the oil pays the storage company a fee. The storage company cannot now go out and sell the oil - that would breach their contract.

Time and time again, throughout history, bankers have attempted to turn monetary irregular deposits into monetary loans in order to speculate with their customer's deposits. Throughout history, from Ancient Greece to the early 20th century it has been determined in courts of law that this practice is illegal. We have institutionalized it. We have created all sorts of fancy schemes in order to cover up this misappropriation (think FDIC). And we have central banks who attempt to mandate positive inflation which encourages depositors to seek return rather than safety with their life savings.

We need a banking system that clearly separates the two kinds of contracts: Depositary Institutions and Loan Intermediaries. With such a system, the central bank's ability to perpetually inflate will be castrated and a truly free-market would be able to prosper (something we have never had). Note that this does not require a gold standard for discipline. A currency could be denominated in anything so long as the legal principles of the monetary irregular deposit were upheld.

Addendum:

To elaborate on the last point. I am not in favour of a legislated gold standard. Although I do believe gold would have a role to play as a medium of exchange if it were permitted (ie. if legal tender laws were repealed). Many of gold's detractors fail to discriminate between Gold Exchange Standards, Bimetalism and 100% reserve gold standards. The latter has very few historical examples of any length. But this is conjecture. I am in favour of multiple competitive currencies which may be freely exchanged electronically, provided 100% reserves are kept and available at any time. There is no reason, with our current technology, for this to be prohibitively complicated. I walk into a bakery to buy a loaf of bread. I elect to pay at the cashier from my account with wheat. If the baker doesn't want wheat, he can program his account to immediately convert wheat to gold or land or whatever she chooses. The intermediary charges a small fee each time this occurs.

Separately, other intermediaries may provide participants the ability to borrow from others who are in the market to lend. Rates would vary according to the risk taken and a term would be agreed upon prior to the transaction completed.

Some Austrians argue that this would effectively end the business cycle. I disagree. There would still be a very noticeable boom/bust cycle because entrepreneurs will always display a herding behaviour and fail regularly. However, the busts would not be systemically jeopardizing due to the lack of leverage. Banks would be mere service providers, not permitted to speculate themselves. Thus, their ability to create loans prior to finding lenders, essentially playing arbitrage on current asset prices vs. inflation adjusted asset prices, will be nixed.

The giant vampire squid's blood funnel would be cut off.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 38.09

2009-10-04T07:11:00.000-07:00

Another week of losses for the major averages gives heightened probability that a major top has been reached. There remains, however, numerous market anomalies that one would not expect if "a change in market character" is what one is looking for. This could, in fact, be nothing more than an overbought correction much like we saw in July.

In the "failing to confirm" category lies crude oil, which remains sticky after posting a 6% weekly gain. The US Dollar, which only managed a third of a percent gain for the week, may also be hinting at something amiss with the validity of the selloff.

I remain cautiously bearish until those two above factors resolve themselves. But I would warn against complacency for those holding large long positions. When this major downward movement materializes, it will not be merely a "correction" of the March-September bull market. We will be proceeding to substantial new lows as the economy deflates, deleverages and completely retools for future expansion. In all likelihood, the highs we achieve in the next weeks (or have achieved already at 1080) will remain in place for a decade or longer.

Moving back to the shorter term for a moment, I would point to some of the recent failures in the S&P 500. Strong markets display strong price movement into the ends of days and weeks. For two weeks running now, we have seen midweek tops on Wednesday afternoon and continued selling pressure for the remainder of the week. This shows that traders are more reluctant to hold positions over the weekend.

Also note that there were two very noticeable bullish patterns carved out this week, both of which failed. Failed patterns often lead to sharp moves in the opposite direction.

Market internals continue to weaken. Advancing/Declining issues and volume are both on the brink of displaying their weakest readings since March.

Market volatility is also ticking upward and recently displayed a positive divergence with the overall markets, refusing to move significantly lower as the major indices climbed higher in September. Additionally, the VIX has broken a trendline dating back to the October/November '08 peaks. Does this breakout look too obvious?

That's all for now.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Social Mood Conspiring To Halt Reflation Attempts

2009-09-29T07:58:00.000-07:00

It is happening around the world. Populist anger directed toward the financial industry (the creator of inflation) is forcing politicians into uncomfortable positions of austerity just as the politicians congratulate themselves for "saving the world." Social mood, an unstoppable force in both directions, is getting the better of what has almost unquestioningly been referred to as "the recovery."

Paradoxically, there are very few who actually want a recovery. I don't. None of my close friends do. Not if it means another bout of asset speculation, inflation and the degradation of social values that go along with it. As such, few of us are complying with the attempts to reflate. Most are unknowingly putting the kibosh on central bankers by resisting lower interest rates, saving, waiting for lower asset prices, and simplifying their lifestyles.

This is a process - a slow one - so it is not easy to put one's finger on. But where emotions run deepest (politics) we can see the changes clear as day.

Three weeks ago in Japan, the DPJ (Democratic Party of Japan) defeated the LDP (Liberal Democrat Party) handily. It was the first LDP defeat in decades. The DPJ intends to "overthrow the ancient régime locked in old thinking and vested interests, solve the problems at hand, and create a new, flexible, affluent society which values people's individuality and vitality." They claim, "the bureaucracy of the Japanese government size is too large, inefficient, and saturated with cronies and that the Japanese state is too conservative and stiff."

Japanese voters may not know it individually, but collectively they are saying, "we are sick and tired of your attempts to reflate the economy for your own benefit, without regard to the unintended consequences." As such, they voted for a party that promised the ability to make more economic decisions at an individual level, rather than via the central planning bureaucracy.

Whether or not the DPJ acts on any of the above is conjecture. Social mood in Japan is forcing the government into a "strong yen" policy that benefits individual Japanese, rather than large multinational exporters.

Meanwhile, over in Germany a nearly identical shift occurred in their election. The FDP (Free Democrat Party) took a large chunk of votes from the SDP (Social Democrat Party) and will now be the keystone in a coalition with Angela Merkel's CDU. The FDP are best described as "classical liberals" or libertarians. They increased their vote totals by nearly 50% on a platform of reduced economic intervention, lowering the public debt and lower taxes.

Once again, we see voters rejecting the inflationary tendencies of big government. Both the Japanese and Germans dislike their excessive dependence on foreign exports. They both elected governments that disavowed subsidizing exporters at the expense of domestic producers. Political pundits will inevitably paint this as some sort of shift toward "right wing" or "isolationist" tendencies. These are both meaningless terms. Social mood has simply changed. They rejected inflationism.

And yes, this is slowly happening in the US as well as elsewhere to be sure. The Federal Reserve has the lowest approval rating among all US agencies (even lower than the IRS!) The Federal Reserve Transparency Act (better known as the Fed Audit Bill or HR1207) is gaining momentum and is sure to pass in one form or another. Last week, congressman Alan Grayson publicly lynched the Fed's General Counsel Scott Alvarez.

But most revealing is the continued reluctance of the FDIC to tap their credit line with the US Treasury, instead deciding to charge member banks nearly $50 billion in fees. Apparently, getting one's hands on ungodly sums of money is not as easy as it was 6 months ago when news of the government doling out $100 billion for this or that was a near daily occurrence. There are real concerns of a further increase on the government's debt ceiling to be rejected by congress. Populist anger toward the lack of fiscal restraint has put pressure on congressmen and women to think twice before casting a 'yay' vote in favour of anything. Midterm elections are coming up in just over a year. And true fiscal conservatives (ie. Libertarians) like Rand Paul and Peter Schiff are raising big money to fight profligate spending tendencies in Washington.

The three largest economies in the world are slowly experiencing the above mentioned shift. Where inflationary fiscal tendencies of governments have been succeeding, they are now coming under attack. This is in addition to the massive failure that monetary inflation has had since the crisis began. Inflationists continue to believe that both governments and central banks can create inflation at will, while in reality we see that neither can without the complicity of a risk seeking behaviour in banks and individuals.

People's attitude toward debt and speculation has changed. As the process intensifies, debt revulsion will accelerate until frugality itself reaches a level of unsustainable extremism. By the time it is widely understood it will be over.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 37.09

2009-09-27T09:14:00.000-07:00

Readers should focus on potential changes in market character as cited resistance levels (1075) proved too difficult to capture. However, one must avoid becoming too bearish immediately due to the fairly benign nature of the 3 day selloff to date. The tape certainly 'felt' heavy, with sharp thrusts lower being met with almost no interest from dip buyers. There have been a number of similar selloffs along this most recent July-Sept rally, but 3-5 days and around 4% seems to be all that can be mustered. In order for me to have confidence that we have seen an important peak, the selloff needs to continue and accelerate to the downside early this week. Otherwise the recent market action must be considered as nothing more than an overbought 'exhaling' and temporary in nature.

Here are 3 conditions I am looking for to confirm that a top is in place:

1) Consecutive daily declines exceeding 2.5%. Since March, the S&P 500 has not managed to achieve this (if so, only marginally). Thus, any decline that is not immediately bought can be considered a change in market character.

2) Continued bullishness being displayed by the media. Daneric's Blog has noticed that there has been a change in sentiment in the media over the last week. During previous selloffs of the same magnitude, it was quickly jumped on as a sign of a potential top. The media and most pundits seem far more confident this time around. "Nothing to worry about," they claim. If this attitude continues, the denial-migration-panic cycle can take hold where another 'point of recognition' kicks off the next bear leg down.

3) Weaker market internals than previously experienced since the beginning of March. Among them:

The 10 day moving average on the Put/Call ratio should pop up above 1.00 for the first time in many months. This would point to a sustained period of bearish options bets - often associated with impending market declines.

The 10 day moving average of the Advance/Decline ratio should also make new lows for the March-Sept period. Again, this would signal a change in market character as weakening leadership is often a good signal of market tops.

We have the recipe for a major market top. It is now left to collect the ingredients. And it is my feeling that they must show themselves soon, lest the dip buyers are emboldened and the manic attitude sets in again for an assault on new highs. I will be prepared for either outcome.

I am also intently watching the oil market for signs of further weakness. Oil and commodities in general have proven to be a good indicator of risk appetite. Speculative credit flows and risk appetite are the driver behind all asset markets and commodities are no different. Notice that crude has backtested its trendline from the lows and reversed quite hard. Also notice the massive negative divergence on the RSI.

Last but not least, the dollar index is again working on a potential bottom. I would be among the 3% who count themselves as bullish on the US Dollar. Being in such a minority has proven profitable many times over the years. I am confident it will again. I would want to see the index jump above its 50day EMA - something not achieved since April - before confirming a bottom is in place.

Do note, however, that the various components to the dollar index had some wild divergences from normality. The Pound took a drubbing while the Euro hardly budged. And the Yen logged large gains and is approaching its highs from Dec/Jan. When the currency markets speak, equity and commodity investors/speculators would be wise to pay attention.

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Bloggin' Ain't Easy!

2009-09-22T09:43:00.000-07:00

Regular readers have surely noticed the drop-off in macro related articles on my blog over the last month or so. The reasons for this are numerous. First, I noticed that way too little time was being devoted to what actually makes me money: finding ideas and trading off them. Getting settled into a new apartment always saps more time than one expects, and I've been working on a new website that moves away from the standard blog format to something more multi-function. The word 'blogger' is thrown around fairly recklessly these days (when not used inflammatorily). And it hardly does justice to the wide variety of commenters that make up the 'blogosphere.'

The world of media is rapidly changing. Even over the last two years, I have seen the concept of blogs change rapidly - from purely opinion driven reports to multi-author news sites that report everything and anything related to the field of interest. Other than the odd late night glance at Bloomberg, I receive none of my information from mainstream media outlets. I have a team of people whose judgement I trust (found via trial and error), and their articles are sent directly to my Google Reader feed. I trust these people far more to filter the good information from the bad than I do anyone writing for major media outlets. For example, on Friday evenings if I want to know how many banks have failed, I can rely on both Rolfe Winkler and Calculated Risk to provide me with the details - faster and more efficiently than anyone else.

Every blog has its own style. Some attempt to report everything making a buzz on that day. Felix Salmon will apologize for missing a story. I prefer to avoid such practices, first because I don't think most of what happens is relevant to many people (based on my contrarian position on causality), and second because it can be incredibly time consuming to do so. I prefer to focus on the price action, human behaviour and inflationary vs. deflationary forces. Yet repeatedly focusing on the same issues can at times feel redundant.

I used to post more ideological attacks on Keynesians, Monetarists, central bankers, etc. That too becomes redundant and even when trying to have discussions with prominent economists, the conversations eventually turn into mudslinging and childish accusations.

So it turns out that my own personal style is to be far more limited in the quantity of posts, but by focusing on the issues that I feel are most relevant I can ensure that the quality remains high. The likely result is that I turn my weekend Technical Updates into more comprehensive articles focusing on macro and sentiment issues in addition to some technical analysis.

So for those of you looking for more daily commentary, I invite you to frequent the "Recommended Reading" tab on the right hand side of my page. The articles posted there are handpicked by myself as I scan through about 150-200 articles and blogs per day (Google Reader even keeps track of how much I read). This is a time consuming exercise, but I do it anyway. So for those who don't have the time to do this themselves, let me do it for you. Some days there will be 10 new posts, others only a few. I have a new application that is bigger and gives a summary of each post. I'll have that up in conjunction with the new site (ETA December).

I just thought I would keep my readers posted with what is going on and what to expect in the future. As always, I thank my regular readers for their comments and continued support. This blog has been a work in progress and a great learning tool.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 36.09

2009-09-21T05:38:00.000-07:00

Another week of gains on fairly decent volume is continuing the push into the upper boundary of resistance cited in my May 10th technical update. I noted S&P 1075 as a potential level of resistance as it marked the "point of recognition" back in September of '08. 1075 was a very obvious level of support at the time as it marked a number of long-term moving averages and trendlines. The S&P closed the previous week around 1100 and gapped lower the following Monday to about 1060. Price has only returned to fill that gap now, a year later. I find that gap fills are particularly useful targets when used in conjunction with the Elliott Wave rule of price returning to the wave (4) of 3 of a lower degree - which has already been achieved on the S&P, while the Dow appears to be satisfying both targets at the moment. If price were to reverse from these levels, I would have more conviction that the Elliott Wave consensus of a Primary Wave 2 is the correct marking for this rally - which would be disastrous for stocks over the next 2 years.

Today, I will show 3 separate time frames of the S&P, as I think it is important that readers see how using the separate intervals can also increase one's conviction if they are to all align nicely in forming a hypothesis. The first chart below is of the daily. One can see that the 200 day moving average (green line) may not prove useful in terms of forming a price target. Price often slices through this line. However, it can prove useful if used another way. One can calculate the distance from the moving average and use that as an oscillator. The further away from the line, the more "pull" it should exert on bringing price back within its grasp. Back in March, we were at historic distances from this line. Today, we stand 20% above the line. (note: I typically use exponential moving averages, but for the purposes of this indicator, I've used the simple MA).

Next chart is of the weekly timeframe. In using moving averages, it is important to note that certain averages tend to be more "in play" than others. If price has often reacted from a certain average in the past, it is more likely to do so in the future. If an average acts as support in an uptrend, it will likely act as resistance on an ensuing downtrend. Such is the case with the 100 week EMA. Going back nearly a decade, we can see numerous instances of fairly major intermediate tops or bottoms occurring from this line. See the pink line below. We have returned to that line as of 1075. If it acts as resistance here again, I would have high confidence that a major top was in.

Lastly, we will look at the monthly chart. One can see how the RSI on this chart was at historic oversold readings. It has now recovered to the midpoint, which typically serves as resistance in a secular bear market as it does support in a secular bull. However, so long as it resides under 60, we can say that the bear lives on - which could give it considerable upside should it choose to drag on for another 2 months or so. Additionally, notice how the current level has acted as support and resistance numerous times over the past 12 years. 1075 appears to be somewhat of a bear market pivot if the bear is looked at to have begun at the 2000 top.

That's all for now!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

The Bear That Cried Wolf

2009-09-16T08:25:00.000-07:00

Bears are getting frustrated. They've been told for months now that "the market appears overbought" and that "technical resistance overhead will prove too tough for a continuation." Only to see price slice through these levels like a hot knife through butter, forcing them to cover their shorts.

I admit to being among the above. Thankfully, I have refrained from making overly bearish bets without the confirmation I need and being disciplined with stop losses. I have also eased the pain by taking some fliers on momentum stocks verging on breakouts. I've heard a number of stories from bears who haven't been so lucky.

The scenario reminds me of the August to October period of '07. Those who had been screaming about the housing bubble and subprime mortgages were proven correct in a mini panic with the market dropping from 1555 to 1370 between mid July and mid August. But the Federal Reserve began cutting interest rates and this was enough to convince nearly everyone that the worst was behind them. The market wound higher over the next two months on extremely light volume - even surpassing its July highs. Divergences were plain to see. Financials were lagging badly. Overall breadth and volume were weak. But most brushed this aside - "mere growing pains," they said.

I hear the same comments today from those who were very cautious in spring and skeptical in the summer. Autumn has come and they are bullish. I notice that my trading account is sporting its largest net long position in a long time - so I am no different. Many other commentators are falling over themselves to make the most bullish short term projections. 1100, 1200, 1350 by year-end. Even the bears, myself included, refuse to suggest that it is impossible. If a 50% rally was possible on very little fundamental improvement, what's another 20 or 30%? I hear "fundamentals don't matter in a market dominated by machine traders." Those who proposed that people "buy low and sell high" are suggesting they again "buy high and sell higher."

The driver behind it all, as I have maintained all along is mood and risk appetite. "Performance anxiety" is a term that explains the phenomenon well for money managers. If they want to be sitting at their desk in January, they better damn well make sure they buy. Anything.

Jeff Cooper of Minyanville writes today:

I just got off the phone from one of the smartest hedge fund managers I know (who went out on his own after a stint with one of the legends in the industry).

Jeff: "What are the folks you respect saying here?"

Hedgie: "Everyone of them who are smart enough to be long are qualifying their position by saying, 'We're long but there is nothing fundamentally that justifies it'"

Jeff: "In other words, they all feel they are skating on thin ice, but it's recreational and they all feel they'll be smart enough to be off the ice if it cracks?"

Hedgie: "Last time I checked, when ice just cracks, there is no warning."

I had thought that the rally would end on a whimper; slowly rolling over and accelerating thereafter. But the unrelenting bullishness of Wall Street is setting up for an epic failure. It is a game of musical chairs. Only instead of dancing to music, Wall Street is having a bonfire with the chairs, dancing naked around it and chanting to the theme song from Mad Money.

There will be no sitting.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 35.09

2009-09-13T18:41:00.000-07:00

Another week of gains for major market averages goes by on low volume as buyers of near-term volatility are punished. With some major divergences in the currency and bond markets, many are left scratching their heads, wondering which way is up. The overnight futures markets are down significantly Sunday night, setting up for a potential heavy week of trading. Triple witching occurs this coming Friday - a quarterly occurrence that typically brings larger than average moves in the days prior.

On May 24th, I wrote:

Ideally, the current rally would last 6 months or longer and do its best job of convincing as many people that the worst is over. Even thought it may sound like that has already occurred, judging by the cheerleading in the MSM, the prevailing opinion is that the recovery, when it arrives later this year, will be weak. I expect a vast majority of the media darlings like Roubini, Krugman, Greenspan and Bernanke to give official claims of an "all clear" as a signal that the bear market is set to resume. Call me a cynic>.
The 6 month rally has occurred and the optimistic tone from many prominent figures is easily noticeable. The OECD recently announced that the global recession is over. Tonight, president Obama will make a victory speech on the economic recovery. And Ben Bernanke, along with a chorus of other economists, is busy congratulating himself in "saving the world." Go figure.

I continue to monitor the relentless bullishness of Wall Street in contrast with the sticky pessimism of Main Street. And while it could be claimed in the early months of the rally that the former should lead the latter, doubts will start to percolate after 6 months and only marginal improvement in the general economy. Any precipitous decline in the stock market runs the risk of quickly accelerating to the downside as the "here we go again" mentality causes a run for the exits. I see this potential when reading between the lines of market pundits and analysts interviewed on TV. They are almost always focused on the possible next 10 or 20%. All of their prognostications are dependent on "fundamental economic improvement." As soon as any early signs of this not happening are sensed, their valuation models will completely disintegrate - panic will result.

The move from early August has been very weak. The RSI continues to diverge as do most other momentum indicators. Increased caution is warranted.

While the Dow Industrials and Transports have confirmed each other's recent higher highs, the Dow Utilities have refrained from a similar indulgence. Utilities are a key sector in my opinion due to their extremely high levels of debt. The ability to refinance (or lack thereof) may be a factor in its recent underperformance.

The market for US Treasuries has been very strong of late, even amid regular auctions (increasing supply). Demand, however, appears insatiable as prices march higher sending yields lower. The long bond usually moves in negative correlation with the equity market. While they can always trade on their own courses for a time, the sheer amount of capital required to sop up the extra supply in both equities and bonds will likely result in only one winner. At some point in the future, I can see longer dated treasuries become more of a "risk asset." But I don't think we are there yet.

The recent movements in the Japanese Yen should have readers very concerned. Could the new Japanese government be pondering a liquidationist mantra? I admit to having no edge on the Japanese endgame. Clearly, they are 20 years ahead of the west in the collapse of their debt bubble. But I am sure the Japanese carry trade is alive and well. And I would not be quick to dismiss the possibility of enormous liquidations of foreign assets by Japanese investment banks and hedge funds. Below is the Yen in comparison to the Euro. This has proven to be a quite useful measure of risk appetite.

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Of Resistance And Reactions

2009-09-10T07:49:00.000-07:00

Markets look like they want to extend. Albeit in a very fractured manner and on very low volume. I had expected quite an expansion in volume this week. It hasn't arrived.

Many bearish commentators are looking for a 'catalyst' in order to get stocks moving lower again. This is backward. There are catalysts every day. Yesterday's consumer credit numbers were terrible (good for consumers, but bad for a credit based economy.) International capital requirement standards have been making the rounds as well - in conjunction with IASB and FASB accounting changes for banks. Trade tensions have been heating up between China and western nations.

The difference between these 'catalysts' and the ones being talked about by "the bears" is nothing more than market reaction. A catalyst is only catalytic if the market reacts to it. Otherwise it is ignored. Hence it is not the catalysts we need to be watching for. Only the reactions.

Nobody in their right mind would even attempt to justify weighting a 10,000 person difference in weekly unemployment claims higher on a scale of importance than a $20 Billion dollar drop in monthly consumer credit figures. But if the market is higher after the release of such information, you can bet your bottom dollar that the financial news media will credit the former as cause for the rally.

Social mood is at euphoric highs if one were solely focused on the financial world. But pessimism abounds on Main Street. This can be seen in presidential approval ratings, assessments of the current job market, and consumer confidence. Bulls will point to this as fuel for a continuation rally, as they claim these retail investors are "underinvested" in equities. Such claims are, of course, way off base. They are made simply by looking at historical participation rates, noticing that they are below the upward trend of the past 30 years and suggesting they must move higher. This does not take into account that perhaps retail investors are not buying stocks because they've decided their rate of saving has been way too low for over a decade. Perhaps they've decided that paying over 10% of their incomes for debt servicing costs is too much for them, and they'd rather pay back the debt than attempt to outpace it with gains in the stock market. Perhaps these retail investors see the growing federal debt and sensing a higher future rate of taxation, they are setting aside cash for such an inevitability.

Optimism may reign on Wall Street, but I don't think Main Street will play "catch up" anytime soon - as most analysts are expecting. But I would warn readers not to underestimate the potential of Wall Street euphoria to continue even longer than most would rationally expect. Remember back to the late 90s. Most respected market analysts had correctly identified the Nasdaq bubble as such in the lead up to the Asian Financial Crisis. The Naz managed to double from those levels. China did the same between the spring and autumn of '07. Most of those who were correct about the '07 US market top were also those who had called the entire advance from '03 "illegitimate." It took them 4 years to be proven correct. How many would have told you that there was even the slightest possibility of a multi-year rally if asked in early '03?

That said, this market looks toppy, sloppy and choppy. A perfect recipe for a top - or a failed retest of resistance leading to new highs. Is the mood ready to shift on Wall St?

"The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function. One should, for example, be able to see that things are hopeless yet be determined to make them otherwise." -- F. Scott Fitzgerald

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 34.09

2009-09-07T08:33:00.000-07:00

I hope everyone is refreshed from their long-weekends. The coming week is likely to be one of high importance in determining if the recent peak at 1039 was in fact a lasting market top or just a speed bump.

Last week, I outlined that "the probabilities have materially shifted in favour of a lasting market top." Tuesday's market action provided further confirmation to this, registering a 90% down day. The remainder of the week was characterized by very low volume, declining volatility and moderately higher prices, achieving a 50% retracement of the down move. I am skeptical of the legitimacy of the move as it was on such low volume going into a holiday. However, price is the final arbiter.

In Elliott terms, this looks to be a 2nd wave of some degree, which means that it can retrace all the way back to the high - but no further. Any push past the August 28th high would be very bullish and suggestive of a price target in the 1100 area. But since market action is likely to be of very high volume from Tuesday onward, any push higher that proves it can hold will be enough to turn me more bullish for a trade.

Below is an hourly chart of the last month for the S&P 500. The horizontal lines are common fibonacci retracement levels for wave 2 moves.

98 NYSE issues managed to make new 52week highs on Friday. Along with a fairly solid closing TICKS reading and strong breadth, this throws a bit of a wrench in the plans for a bear raid.

The big story of the week was the sharp move higher in gold, busting out of a triangle pattern and challenging the $1000 mark once again. Readers will find it interesting that gold managed to do this both with higher US Treasury prices and without much of a move in the US Dollar. The internet is filled with theories as to "why" this is happening and "what gold knows" that other asset classes apparently don't. I think Dennis Gartman put it best in an interview I saw with him last week sometime, when he said (paraphrased) 'Gold isn't moving in reaction to anything. It's just moving. It is a market unto itself and right now it looks like it wants to go higher.' That is a simplicity I can agree with.

The aforementioned US Dollar Index appears to have failed in its breakout attempt and looks destined to make new YTD lows before putting in a bottom. This is obviously important to the direction of equities, so it bears keeping in mind.

That's all for now.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Reader Mailbag: Why Such A Focus?

2009-09-01T09:11:00.000-07:00

Reader TH asks a very relevant question with regards to the focus of my attention over the past year or so.

Paraphrased, TH wanted to know why I spend so much time deliberating over the potential forces of inflation and deflation rather than focusing my attention of some of the more prospective new technologies and investment opportunities of the future. He contends that there are opportunities to make money in any market environment and wonders if my time would be better spent searching for those, as opposed to trying to "predict the future actions of madmen."

TH raises some very good points here. Indeed, there are many new technologies that I am very positive on. Nanotech would probably be at the forefront of this. There are unlimited applications for a technology that literally allows one to rearrange the building blocks of life (molecules) to conform to one's needs. This is not a new concept. But the underlying technologies have become much cheaper than the two previous speculative booms that the sector enjoyed (and then suffered through) in 2000 and 2004. Very much like the concept of the computer was posed decades before it became a useful tool, in time nanotech will gradually begin to make waves on our lives and economy. The companies that are able to be at the forefront of this will likely become some of the better investments of the next few decades.

Additionally, I still believe there are advancements to come in communications and networking. The recent introduction of "smart phones" is probably the most notable manifestation of this. Network speeds and accessibility are enjoying exponential growth. With it, they are redefining what people are able to do "away from the office." Often seen as a gimmick for text messaging friends and other social networking time-wasters, the open source nature of these things are enabling people to do away with numerous other burdensome tools and making us more productive in the process.

Another area that I see new and exciting growth opportunities are in so-called "new media." I am already invested heavily in this industry - via this blog. I don't think anyone can honestly say what the next medium will be for the transmission of news media, entertainment, or advertising. But it is apparent that it will be far more customizable and "on demand" than previous versions. There will be little bubbles along the way - for the life of me, I can't figure out what draws people to Twitter. And yes, I'm aware of the irony that blogging is itself a potential bubble.

So back to the original question from my reader TH. Why don't I spend more time talking about this kind of stuff?

The short answer is because even though I want to be invested in these technologies, I firmly believe I can do so at a fraction of the price in 2-5 years down the road. And this belief is best conveyed with an understanding of our current deflationary situation. If it were inflation that I saw in the near or intermediate future, I wouldn't care much for valuations or balance sheets. I would be buying assets on margin in expectation of their imminent explosive growth.

As I began my research into financial markets, the first area of interest for me was in understanding the history of markets. I suppose it would have been easier if I became enamored with the impressive growth of homebuilding stocks, but that seemed all too short term and frivolous to me. I was after the big picture. The more I began to research this, the more it became clear to me that successful investing rarely had much to do with picking stocks. Rather, it had more to do with making the right decisions in asset allocation once every 10-20 years. That's all that seemed to matter.

Think about it this way. Among those who were entering midlife in the late 60's/early 70's, how many managed to fully benefit by buying real estate and commodities with borrowed money at a low fixed rate of interest? And later on in the 70's how many had the acumen to sell those assets and buy stocks? And in 1999, at the height of the tech bubble, who in their right mind would sell everything and buy government bonds - and hold them for a decade?

The answer to all those questions is "not many." However, anyone who did make even one of those decisions was likely made very wealthy for the remainder of their lives. Any further decisions would have been irrelevant to their overall financial standing. For anyone else, the likely outcome was breaking even at best, bankruptcy at worst. Even those that managed to pick the best stocks through the 70's lost out to inflation. Those that held real estate into the early 80's were eventually forced to refinance debt at interest rates of 20%.

It is my contention that the environment for owning companies is poor, as it has been for 10 years. I could attempt to pick the best among the industries that I mentioned above. If I happen to be wrong - or early - I lose. Take Juniper Networks (JNPR) as an example. I like this company. They provide networking solutions for many of the new technologies I talked about above. They don't have as much risk as the underlying technologies because they simply service the needs of other companies. But they are trading at 22x their forward projected earnings and pay no dividend. Twenty two times! Of course those projected earnings could be affected by exogenous risk factors that have nothing to do with the company itself. How can I buy this with a 10 year horizon if I think there is a realistic possibility of it dropping 60%? I encounter the same conundrum in nearly every business that I feel has good growth prospects.

So we come back to the question at hand. Inflation or deflation. If it's inflation, I hold my nose and buy 'em. If it's deflation, I remain patient and wait for that 60% correction or more - yes even from these levels. It is a binary outcome. Hence, the focus of my blog and my attention is in determining this outcome.

Managing this will prove to be the single most important determinant of the future financial health of myself and my readers.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Technical Update 33.09

2009-08-29T17:49:00.000-07:00

The probabilities have materially shifted in favour of a lasting market top. Of the 2-3 dozen market indicators I follow, all but a few are consistent with this hypothesis. If you would have asked me in April what I thought would coincide with a bear market rally top, I likely would have answered the following:

- extreme bullish readings from sentiment indicators (DSI, AAII, Investors Intelligence, bullish percent index)
- bullish proclamations from prominent analysts, investors, economists, central bankers and politicians
- media embracement of "a new bull market" via magazine covers and daily cheerleading
- persistently weak economic fundamentals inclusive of deteriorating credit conditions and banking failures
- negative divergences in the currency, commodity and bond markets
- negative divergences in momentum indicators (ie. RSI, MACD, Stochastics, etc)
- declining volume throughout the rally
- decreasing volatility
- countable Elliott Wave corrective patterns
- DeMark sell signals
- Dow Theory non confirmation

Among the above, nearly all conditions have been met. It would be wise to keep an eye on the few that have not yet been met.

- The Dow Theory, by many interpretations, has recorded a buy signal. Some interpret it differently, however.
- DeMark sell signals will record if we have a close below the close 4 bars earlier with followthrough on the next open (any close next week below S&P 1025 should do the trick).
- Elliott wave count could be suggestive of higher prices (I'll cover this more below)
- Although volatility is declining, options traders are overwhelmingly betting on higher volatility (declining prices) in September and October.

For volatility, it is important to note that when looking at the VIX, one is looking at option premiums for 1 month in advance. The VXV, however, measures volatility 3 months forward. The VXV is trading at quite the premium to the VIX. Additionally, historical (realized) volatility has been quite tame. And there has yet to be any "capitulation" in the premiums being charged. In fact, the spread between implied and realized volatility is at multi year highs. This may be something to keep your eye on for the following week, which happens to be the week before a long weekend (monday the 7th) and typically of very low volume.

It is worth pointing out, however, that back in October and November, when volatility was at very extreme readings, the VXV (3 month) was trading at a discount to the VIX (1 month). This proved to be correct as volatility was indeed more muted over the following months. There is no reason (other than contrarianism) that the same cannot prove to be true today with higher volatility being priced in. See chart below:

What is ambiguous about the Elliott Wave pattern (skip this if you don't understand Elliott) is the labeling of the final wave C of (Y). Since the March low, either a "zigzag" or "double zigzag" appeared to be playing out. The highs around 940 in early June marked the first zigzag, however there were not enough other factors (like those mentioned above) for this to mark a high, and a double appeared to be the most likely scenario. So from the 869 low to about 1018, we had an A wave, followed by a B wave retracement to 979 and a subsequent 5 wave rally to Friday's opening high of 1039.47. What is still up in the air is whether the recent 5 wave rally is simply wave (1) of a bigger rally past 1100 or not. I do not think this is the case, but it remains a possibility. Should a strong rally blow past 1050, this would likely become the higher probability scenario. If prices were to rise moderately early next week, we may be witnessing an "ending diagonal" that would terminate itself around 1050.

The chart below is courtesy of Daneric's Elliot Wave Blog.

As I mentioned earlier, the dollar and many commodities have failed to confirm the move higher in equities. Treasury yields, additionally, are well off their lows. If stocks are ready to push higher, these divergences need to disappear.

Lastly, I want to revisit something I was following a few months ago.

One should always be wary of an irrational market to persist longer than initially believed possible. And it should also be mentioned that corrective waves have a tendency to last a minimum of 1/3 the duration of the preceding secular trend. Marking the beginning of the trend as Oct of 2007, the first wave lower was 17 months in duration, meaning that this corrective rally should last at least into the end of the summer. Sharp pullbacks, however, can easily interrupt this path. And that is my primary expectation - that we see a sharp pullback of 10-20% in the near term, followed by a late summer challenge of, and perhaps exceeding of, the recent highs (S&P 956).

We did get our pullback (it was rather dull, though) into July of about 10%. And we did exceed the June highs of 956 (by quite a bit). We have also passed the 1/3 retracement in terms of time. This rally has lasted 25 weeks compared to the decline that lasted 61 (40.9%). Measured in constant dollar terms and using May '08 as the high, our 42 week decline will be contrasted with a near perfect Fibonacci 61.8% retracement next week. Something to think about... or not.

That's all for now.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

In Transfer

2009-08-27T17:28:00.000-07:00

Apologies for the lack of content of late. I'm in transfer mode right now. New apartment. New website coming. Starting up some side projects. And repositioning my trading account for a potential top.

In the meantime, I have made my Google Reader favourites available for all to see. I scan through over 100 blog posts and newspaper articles on any given day (as I get faster and more efficient at doing this, it seems, the list grows). I will flag the ones that I think are most important and they will show up on the right hand portion of this page under "Recommended Reading." I won't necessarily be in agreement with everything posted there. But if it is presenting an interesting contrary opinion and is relevant, I may give it a nod.

This will likely be a larger part of the new website where I will refrain from posting more than a weekly missive on technical and fundamental issues.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Transparency 1 - Federal Reserve 0

2009-08-24T18:52:00.000-07:00

Score one for the good guys.

Aug. 24 (Bloomberg) -- The Federal Reserve must make public reports about recipients of emergency loans from U.S. taxpayers under programs created to address the financial crisis, a federal judge ruled.

This is a major victory in the battle against encroaching central bank power over the US economy. This also sets a major precedent in eventually allowing for a total audit of the Fed (perhaps making HR 1207 redundant).

I hope the judge has protection.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

On The Calculation Of GDP

2009-08-24T09:27:00.000-07:00

Rolfe Winkler who writes one of the Reuters blogs - formerly of Option ARMageddon posted a really good quote from Bobby Kennedy circa 1968. It reminded me of something else I had read.

They both have to do with the absurdity of how we calculate our economy's progress - namely GDP (formerly known as GNP). Just as looking at someone's income bracket and trying to make a determination of how "happy" they are, it is a bit of a stretch to simply measure the amount of economic activity as if "activity" can simply be defined as one homogeneous unit. It cannot. Some activity is legitimate progress. Some activity shows progress now, but is only at the expense of a necessary future regression. Other activity is just plain damaging from the outset.

Unfortunately, making such determinations about the nature of economic activity is extremely subjective. It is so for the same reason that many people find living on an income of $20,000 very comfortable, while others cannot do without $200,000. Neoclassical economists try to label one as rational, and the other as irrational. This way they can eliminate the irrational from their models. By doing so, they allow their own subjective values to reflect themselves in the numbers that result from these models and the policies that are then recommended. They know of no other way. If these economists were forced to admit that they cannot even judge the total economic activity in a nation, they would be completely disposable. GDP calculations are used as the anchor for virtually all other economic models.

Kennedy's quote below highlights the social degradation that inevitably results from focusing on absolute numbers rather than the quality and independent nature of each input. It could have been said today - more than 40 years later - as increasing focus is put on financial innovation and accounting tricks to "meet the number," while we accumulate more and more long term debt and watch the manufacturing portion of our economies erode to an afterthought.

Too much and for too long, we seemed to have surrendered personal excellence and community values in the mere accumulation of material things. Our Gross National Product, now, is over $800 billion dollars a year, but that Gross National Product - if we judge the United States of America by that - that Gross National Product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear warheads and armored cars for the police to fight the riots in our cities. It counts Whitman’s rifle and Speck’s knife. And the television programs which glorify violence in order to sell toys to our children. Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile. And it can tell us everything about America except why we are proud that we are Americans.

-- Robert Francis Kennedy, speaking at the University of Kansas, Lawrence KS, 3/18/68

The quote reminded me of something I had read along the same lines by Lawrence Parks. Burn Your House, Boost The Economy:

As recently as 50 years ago, economists regarded the vitality of the economy as consonant with its ability to produce things people want (and would pay for). Today, the economy has been redefined into something called the Gross Domestic Product, or GDP. It measures all goods and services brought to market in a given year. But is it really an accurate measure of how well an economy is serving people's needs? Here are some outlandish ways the GDP can be boosted.

Things Kids Can Do. Get sick. Constant medical attention is good for the GDP. Medical costs account for 14 percent of it. Let's stay on the growth curve. Kids can also become juvenile delinquents. If they get arrested for heinous crimes, they go to jail, the expensiveness of which gives the economy a jolt.

Things Adults Can Do. Get a divorce. Legal costs, two houses, and all the things that go with two houses (furniture, kitchen supplies, pictures, etc.) are important components of the GDP. Divorces stimulate consumer demand.

Break something around the house, like a television, a dish, or a window. Replacing these increases the GDP and creates jobs.

Smash up the car. It will have to be fixed or replaced. The auto industry employs, directly and indirectly, one of every seven workers in the U.S., and they need the overtime.

For great results, burn down the house. Don't worry. If you handle it right, insurance will pay for it and the rebuilding will keep a lot of people busy for a while.

Quit your job as a scientist and become a taxi driver. Research and development is not included in the GDP, but money spent on taxicabs is.

Overeat, don't exercise, don't brush your teeth, do drugs, smoke, drink, and make yourself terribly sick. Get family members to do the same. Higher medical expenditures especially help the GDP move up, up, up.

Hire help to take care of the kids, and force your wife to get a job. This gives the economy a double boost. If your wife takes care of kids and cooks, this is not counted in the GDP. Hired help is. If she gets a paycheck too, that counts towards measuring economic growth.

Hire a lawyer and sue somebody. Lawyers' fees are directly added to GDP.

Things You Can Do With Your Neighbor. Riot and burn the neighborhood. The damage won't be subtracted from GDP. But rebuilding puts people to work and benefits the GDP.

Form a gang and commit crimes with a view to getting caught. The more people in jail, especially folks who would not otherwise have jobs, the better off the economy. Today, building and managing jails is one of the hot "growth" industries, to say nothing of the security business.

Things Businesses Can Do. Pollute. A giant oil spill would be great. Superfund sites expand the GDP.

Leverage up and build excess real estate, e.g., see-through buildings. They add to the GDP when they go up, but the waste is not subtracted when they are demolished. Similarly, companies can build excess plant capacity (as IBM did in the mid-to-late 1980s to the tune of $30 billion).

All of this counts toward GDP. Again, when companies are "downsized," nothing is subtracted from the GDP. It's similar in concept to the "roach motel": GDP counts the things going up, but not going down.

For Best Results, Get The Government Involved: Lobby your elected representatives to raise taxes and spend more money. Government spending on goods and services adds to the GDP and "creates" jobs.

Start a war. Preferably one far away where no Americans get killed. B-2 bombers, tanks, bullets,...all count in the GDP. Also, send Stinger missiles to liberation armies around the world. Maybe some of these missiles will be used to knock down airliners. Replacing them helps the economy, and, if lawyers get involved, there's a GDP bonus.

Target savers! People who save actually hurt the economy because they don't spend. If people spend their savings, then those purchases are added to the GDP. When they don't spend, the economy suffers. What can be done to discourage saving? First, tax the return on savings: a higher capital gains tax would be very helpful. Second, and best, debase the currency. By printing up more and more money, we can dilute the value of people's savings (especially their long-term savings such as their pension funds) surreptitiously stealing their savings for politicians to spend and thereby increase GDP.

Get Mother Nature On Your Side. Pray for a natural disaster: a hurricane, an earthquake, a big fire, a flood. Disasters give the GDP a tremendous life because of all the rebuilding that must take place.

If we do all these things, we'll have enough statistical growth to replace decades of economic stagnation. We may achieve double-digit rates. As for whether the economy is actually vibrant, we'll have to ask an economist who exercises more critical judgment than those who swear by GDP data.

I suppose GDP could register a positive reading for the 3rd quarter. Perhaps the 2nd is revised higher as well. But what exactly would that be telling us? What would it mean for the millions of newly unemployed workers who can't find jobs in anything close to their area of specialization? What would it mean for the heavily indebted who see no rise in their incomes as assumed when they chose their payment plans? The numbers, as always, will be completely meaningless for individuals who make their decisions based on their own unique situation, not some vague indefinable concept like "the average person."

Statistics like GDP, price changes (known as inflation), consumption, manufacturing, and wages all focus on "aggregate" numbers. They tell us nothing of what is occurring at the individual level. As such, they are useless for all practical purposes. We'd be better off without them - and the economists who propagate them.

Bobby Kennedy was a Democrat. It would be nice if some of his common sense could be resurrected today.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.